, THE 
ALCHEMY 
READING THE MIND OF THE MARKET 
GEORGE SOROS 
NEW PREFACE FOREWORD BY PAUL TUDOR JONES 11 
,crP* 
John Wiley & Sons, Inc. 
New York Chichester Brisbane Toronto Singapore

' TO SUSAN, 
without whom this book would have been ready much sooner 
A number of people have read all or part of the manuscript at vari- 
ous stages of its development. They are too numerous to be listed, 
but I want to thank them all for their help and criticism. Byron 
Wien, in particular, has gone beyond the call of duty in reading and 
commenting on, the manuscript at three different stages of develop- 
ment. Special thanks are due to Antonio Foglia, who generated the

graphics that illustrate the real-time experiment. Larry Chiarello 
supplied the figures. 
I also want to thank the team that contributed to the perform- 
ance of Quantum Fund during the experiment: Bill Ehrman, Gary 
Gladstein, Tom Larkin, Robert Miller, Steven Okin, Joe Orofino, 
Stephen Plant, Allan Raphael, and Anne Stires.

' I CONTENTS 
Foreword 1 
Preface 4 
: Introduction 11 
I 
Part I 
THEORY 
1. The Theory of Reflexivity 
Anti-equilibrium 27 
The Problem of Imperfect Understanding 31 
The Problem of the Social Sciences 34 e 
The Participants' Bias 40 
The Concept of Reflexivity 41 
Reflexivity versus Equilibrium 43 
2. Reflexivity in the Stock Market 
3. Reflexivity in the Currency Market 
4. The Credit and Regulatory Cycle 
Part I1 
HISTORICAL PERSPECTIVE 
5. The International Debt Problem

5. The International Debt Problem 
6. The Collective System of Lending 
7. Reagan's lmperial Circle 
8. Evolution of the Banking System 
9. The "Oligopolarization" of America

vi Appendix 
Part I11 
THE REAL-TIME EXPERIMENT 
10. The Starting Point: August 1985 
11. Phase 1: August 1985-December 1985 
12. Control Period: January 1986-July 1986 
13. Phase 2: July 1986-November 1986 
14. The Conclusion: November 1986 
Part IV 
EVALUATION 
15. The Scope for Financial Alchemy: An Evaluation of 
I the Experiment 
16. The Quandary of the Social Sciences 
Part V 
PRESCRIPTION 
17. Free Markets Versus Regulation 
18. Toward an international Central Bank 
Exchange Rates 328

Exchange Rates 328 
International Debt 329 
Oil 333 
An International Currency 338 
19. The Paradox of Systemic Reform 
20. The Crash of '87 
Epilogue 361 
Notes 366 
Appendix 368

I 
I 1 FOREWORD 
Four hundred seventy-three million to one. Those are the odds 
against George Soros compiling the investment record he did as the 
mabger of the ~uantum Fund from 1968 through 1993. His invest- 
ing record is the most unimpeachable refutation of the random 
walk hypothesis ever! 
As a trader coming of age in the latter half of the frenetic 1970s 
and the 1980s, The Alchemy of Finance was somewhat of a revolution- 
ary book. Remember, this was the period when trend following

and indexation were the vogue in investing. It was a time when 
technical analysis (the study of price movemen? as a forecasting 
tool) reached its zenith. Traders of my generation armed them- 
selves with charts and computer-generated graphics that predicted 
future price direction. We sat day after day in front of screens, mes- 
merized by blinking lights and everchangir~g numbers in a deafen- 
ing cacophony of information overload. With the possible exception

of Elliott Wave Theory, an intellectual framework for understand- 
ing the course of social, political, and economic events was notice- 
ably forgotten in favor of just making sure that one was part of the 
ever-quickening process. 
The Alchemy of Finance was a shot out of the dark for me. It let 
me take a giant step forward by first taking a step backwards, 
clarifying events that appeared so complex and so overwhelming. 
During an era when so much money was made in larger than life

events, from the Hunt brothers' squeeze of the silver market in 
1979 to KKR1s takeover of RJR Nabisco in 1989, Mr. Sorosls theory 
of reflexivity is the first modern, nontechnical effort to describe

2 Foreword 
I and forecast the dynamic interplay between the participants in 
the process. That is the brilliance of this book. It describes the dy- 
namics of the path between points of extreme valuation and equi- 
librium in the marketplace. This is particularly important for the 
average investor. How many times have we been correctly long 
near the bottom or short near the top of a major market move? But 
our staying power with these positions has been weak (as well as

our returns) because of a lack of understanding of the path of big 
price moves. Soros gives us critical insight into that path and thus 
more confidence in our investments. This constitutes 70% of any 
successful investing campaign. 
When I enter the inevitable losing streak that befalls every ill- 
vestor, I pick up The Alchemy and revisit Mr. Soros's campaigns. 
+ Studying how he coped with adversity provides an excellent tu-

torial for breaking the string of negative behaviors that occasion- 
ally besets any investor. Winning is infectious. And this book in 
replete with examples of trading behaviors all would want to emu- 
late. Importantly, Mr. Soros's intellect gives him the confidence and 
strength of his own convictions to stay with his positions even dur- 
ing trying periods. In that sense, The Alchemy joins Edwin LefGvre's 
Reminiscences of a Stock Operator as a timeless instructional guide of

the marketplace. And as such, Soros should beware! In the World 
War I1 movie Patton, my favorite scene is when U.S. General George 
S. Patton has just spent weeks studying the writing of his Germany 
adversary Field Marshall Erwin Rommel and is crushing him in an 
epic tank battle in Tunisia. Patton, sensing victory as he peers onto 
the battle field from his command post, growls, "Rommel, you mag- 
nificent bastard. I read your book! " Enough said.

The Alchemy is also an excellent economic and political hijiory oi 
recent times. From unknowingly providing a blueprint as to how 
the savings and loan fiasco in the United States would be resolved 
six years in advance (page 124) to predicting the stock market crash 
of 1987 two years in advance (page 181), Soros reveals himself as the 
great market visionary of our time. 
History will probably remember Mr. Soros as the speculator who

tilted against the Bank of England in 1992 (and freed the English 
people from recession). His billion dollar score is simply too com- 
pelling a story for scribes to overlook. Mr. Soros himself would 
probably like to be remembered as a great economist or even scien- 
tist. But I am going to remember him for something even more im- 
portant, for which he does not receive the credit he deserves. He is

Foreword 3 
someone who genuinely cares about the state of the human condi- 
tion and tries to better it. His myriad and monumental philan- 
thropical efforts will qualify him as one of history's great 
benefactors. Even today at age 62, he pursues the activities of his 
six foundations with the vigor and work ethic of a young turk on 
the way up the financial ladder, working 18-hour days around the 
globe on behalf of fjis causes. He does not just write checks, which

any wealthy person can do. He is a hands-on workaholic who mate- 
rially impacts the quality of the lives of people less fortunate than 
he. Now this, this is a sign of greatness.

PREFACE 
Seven eventful years have passed since The Alchemy of Finance was 
first published. My investment fund, the Quantum Fund, has con- 
tinued to flourish: Shareholders have enjoyed average annual gains 
of 35. .8% in the last seven years in spite of a setback in the crash of 
1987. Quantum Fund has also spawned a number of offspring, 
some of which are doing even better than the goose that is laying 
the golden eggs. Starting in 1989, we decided to distribute a por-

tion of our earnings to shareholders, either in cash or in shares of 
the newly created funds. As a result, we now manage seven funds 
with combined equity of over $10 billion. 
I have become progressively less active in the management of the 
funds. I was fortunate in meeting Stanley Druckenmiller through 
The Alchemy of Finance. He was managing another fund at the time, 
and he sought me out because he was intrigued by my book. We

started talking and, eventually, he joined my firm. At the begin- 
ning, he found it difficult to work with me. Although I gave him a 
great deal of authority, he was inhibited by my presence and felt 
that he was not doing as well as he had before joining my firm. For- 
tunately, I was becoming increasingly involved in the revolutionary 
process that led to the collapse of communism. I was establishing a 
network of foundations throughout the communist world and it in-

volved travelling in places where communications were rather poor. 
In the summer of 1989, I told Stan that he must take full charge of 
running the Fund. Since then we have had no difficulties. 
I became the coach, and he became the competitor. Our perfor- 
mance improved and we embarked on a period of sustained growth. 
In each of the last three years, we chalked up gains in excess of

Preface 5 
50%. Although we hpve had two similar periods of prosperity pre- 
viously, this qualifies as an exceptional performance in view of our 
outlandish size. Druckenmiller is not only a good fund manager, he 
is also a good partner. Under his leadership, we have been able to 
enlarge and improve our management team so that it now has a 
depth which it never had before. So it happened that I found the 
reward for my philaqthropic activities in the prosperity of my busi-

ness. That prosperity enabled me to expand the foundation net- 
work at a breakneck speed. 
My participation in the collapse of communism is a different 
story which has to be told in a different place. In fact, I have already 
written two books on the subject, Gyersing ihtl Soviei Syslsiem in 1930, 
and Underwriting Democracy in 1991. The point that needs to be 
made here is that I was guided by exactly the same philosophy in 
my philanthropic activities in Eastern Europe as in the financial

markets. As the reader will learn, I treat developments in financial 
markets as a historical process. That makes my theory eminently 
applicable to a histyical process such as the collapse of commu- 
nism. I did apply my theory and on the whole it enabled me to an- 
ticipate events better than most people. As I discovered, there is a 
great deal of similarity between a boom-bust process in the finan- 
cial ma&kets and the rise and fall of the Soviet system.

It is ironic that I b'ecame famous, not because of my activities in 
Eastern Europe, but because of the profit we made on sterling when 
Britain left the Exchange Rate Mechanism on Seember 16,1992. I 
became an instant celebrity, first in Britain, then in the rest of the 
world. When it became known that the Quantum group of funds 
had bought a large block of Newmont Mines, the price of gold 
soared. Although I expressed no opinion or. gold, ail itil3ds ur' opin-

ions were attributed to me. I made some attempts to rebut them, 
but to no avail. Although I had not sought guru status, I could not 
ignore it when it was thrust upon me. In fact, I welcomed it because 
I thought that it would be useful in having my voice heard on polit- 
ical issues. But that was not as simple as it seemed. When I said that 
the Bundesbank's high interest rate policy was becoming counter- 
productive, the markets responded by pushing down the German

Mark. But when I inveighed against European policy on Bosnia, I 
was either ignored or told to stick to the field of my expertise. I 
fared particularly poorly in France, where I refrained from specu- 
lating against the franc because I did not want to be responsible for 
the collapse of what remained of the European Exchange Rate

6 Preface 
I Mechanism, but I was blamed for it anyhow. The French govern- 
ment resented my advice even more than it would have resented 
my speculative activities. It goes to show that speculators ought to 
speculate and keep their mouths shut. 
My notoriety as a financial guru has created a tremendous de- 
mand for The Alchemy of Finance, hence this new edition. I must con- 
fess that my thinking has evolved a great deal since I wrote this

book, but I have been concerned mainly with historical processes, 
not with financial ones. I cannot summarize my ideas in this pref- 
ace-I need to write another book. I intend to do so as soon as time 
permits, but there is one important theoretical point I need to make 
in urcler iu Llir~g iiti~ book in line with my curr6nt thirtkmng. 
In The Alchemy of Finance, I put forward the theory of reflexivity 
I as if it were relevant at all times. That is true in the sense that the

two-way feedback mechanism that is the hallmark of reflexivity 
can come into play at any time, but it is not true in the sense that 
it is at play at all times. In fact, in most situations it is so feeble 
that it can be safely ignored. We may distinguish between near- 
equilibrium conditions where certain corrective mechanisms pre- 
vent perceptions and reality from drifting too far apart, and 
far-from-equilibrium conditions where a reflexive double-feedback

mechanism is at work and there is no tendency for perceptions and 
reality to come close together without a significant change in the 
prevailing conditions, a change of regime. In the first case, classical 
economic theory applies and the divergence between perceptions 
and reality can be ignored as mere noise. In the second case, the 
theory. of equilibrium becomes irrelevant and we are confronted 
with a one-directional historical process where changes in both

yerceptims and reslity ax irreversible. It is important to distin- ,, 
guish between these two different states of affairs because what is 
normal in one is abnormal in the other 
The idea of a distinction between nea rium and far-from- 
equilibrium conditions is present in The Alchemy of Finance. At the 
end of Chapter 1, I distinguish between humdrum and historical 
change but I understate the importance of the distinction. I call it

"tautological." I now consider this a mistake. The tautology arises 
only because I do not probe deeply enough and cover up with a tau- 
tology what is a fundamental difference in the structure of events. 
In most phenomena investigated by scientific method, one set 
of conditions follows another irrespective of what anybody thinks 
about them. The phenomena studied by social sciences, which

Preface 7 
include the finan~ial~markets, have thinking participants and this 
complicates matters. As I have tried to show, the participants' views 
are inherently biased. Instead of a direct line leading from one set of 
conditions to the ne~t one, there is a constant criss-crossing be- 
tween the objective, abservable conditions and the participant's ob- 
servations and vice &sa: participants base their decisions not on 
objective conditions but on their interpretation of those conditions.

This is an important point and it has far-reaching consequences. It 
introduces an element of indeterminacy which renders the subject 
matter less amenable to the kind of generalizations, predictions, 
and explanations that have given natural science its reputation. Ex- 
actly because it is so disruptive; the social sciztnces in general and 
economic theory in particular have done their best to eliminate or 
to ignore the element of indeterminacy. I have taken issue with that

endeavor and tried to develop an alternative approach which takes 
the participants' bias:as its starting point. 
In retrospect, I may have overstated my case. There are many sit- 
uations that can be fruitfully studied by taking the participants' 
bias as given and ignoring the element of indeterminacy which it 
may generate. It is only in certain respects and in certain special 
circumstances that the indeterminacy becomes significant. It comes

into play when expectations about the future have a bearing on 
present behavior-which is the case in financial markets. But even 
there, some mechanism must be triggered for the participants' bias 
to affect not only market prices but the so-called fundamentals 
which are supposed to determine market prices. Apparently 1 have 
failed tokake this sufficiently clear. The message of my boo 
is usually summed up by saying that the participants' value judg-

ments are always biased and the prevailing bias aifects narket 
prices. If that is all I had to say it would be hardly worth writing a 
book about it. My point is that there are occasions when the bias 
affects not only market prices but also the so-called fundamentals. 
This is when reflexivity becomes important. It does not happen all 
the time but when it does, market prices follow a different pattern. 
They also play a different role: they do not merely reflect the

so-called fundamentals; they themselves become one of the funda- 
mentals which shape the evolution of prices. This recursive rela- 
tionship renders the evolution of prices indeterminate and the 
so-called equilibrium price irrelevant. 
Nobody would deny that individual participants operate with bi- 
ased views; but the prevailing wisdom holds that the participants'

8 Preface 
-w- bias can be dismissed as temporary aberrations, so-called random 
walks. That is the point on which I disagree. I now believe this 
point can be more effectively made by drawing a distinction be- 
tween near-equilibrium and far-from-equilibrium conditions than 
by proposing a general theory of history based on the constant 
cross-crossing between perceptions and reality as I have done in 
The Alchemy of Finance. That does not mean that there is anything

wrong with the general theory; it means only that the concept of 
reflexivity becomes more significant if it is reserved for those cases 
where the double feedback mechanism is actually at work. 
The Alchemy of Finance is devoted to the study of such cases. The 
asst c??vious exam.ple is equity lewragirtg where a temporary 
overvaluation of shares is converted into per-share earnings 
4 through the issue of shares at inflated prices. In most of the cases

discussed, the participants' bias involves an actual error in their 
thinking. For instance, in the late 1970s international bankers lent 
too much money to developing countries because they failed to 
recognize that the so-called debt ratios they used to measure the 
creditworthiness of the borrowing countries were reflexive in the 
sense that they were affected by their own lending activity. But 
it is not necessary for the bias to involve an actual error. As I show

in Chapter 3, a freely fluctuating exchange rate system is inher- 
ently unstable because of the influence of trend-following specu- 
lation, yet speculators follow the correct strategy by following the 
trend. 
Judging by the public reaction-which consists mainly of com- 
ments by journalists who read the book superficially or not at all- 
I have not been successful in demonstrating the significance of 
reflexivity. Only the iirst part of my argument-that the prevailing

bias affects market prices-seems to have registered. The second 
part-that the prevailing bias can in certain circumstances also af- 
fect the so-called fundamentals and changes in market prices cause 
changes in market prices-seems to have gone unnoticed. 
The fault is at least partially mine. Since reflexivity changes the 
structure of events, I have tried to put forward a reflexive structure 
as the universally valid way of looking at the evolution of market

prices-a kind of general theory ZI la Keynes in which the absence 
of reflexivity constitutes a special case. It would have been better 
to present reflexivity as the special case because what endows re- 
flexivity with significance is the fact that it operates intermittently.

Preface 9 
Once the significance of reflexivity has sunk in and the inadequacy 
of the prevailing wisdom has been recognized, the time would have 
been ripe for proposing a general theory of reflexivity. 
I have my excuses. I did not observe reflexivity in financial mar- 
kets but developed reflexivity as an abstract philosophical concept 
before I entered the financial markets. In other words, I failed as a 
philosophical speculptor before I succeeded as a financial one. Ap-

parently, my failure as a philosopher carried over into my book be- 
cause I did not make the concept of reflexivity-which can be 
observed and converted into profit-as clear as it could be. When 
one discovers something new, one has an understandable inclina- 
aon to exaggerate it$ importance. This is what I did with reiiexiv- 
ity. By proposing a general theory of reflexivity, I may have gone 
too far too soon. I claimed that economic theory is false and social

science is a false metaphor. These are exaggerated claims. Since far- 
from-equilibrium conditions arise only intermittently, economic 
theory is only intermittently false. And the dividing line between 
natural and social sqience is not quite as hard and fast as I made it 
appear when I wrote the book. These qualifications render reflexiv- 
ity more rather than less significant. 
Once the concept of reflexivity is established, the range of its ap-

plicability seems to widen. It is possible to treat the evolution of 
prices in all financial markets taken together as a reflexive, histori- 
cal process. I have done so in The Alchemy of Finance when I ana- 
lyzed Reagan's "Imperial Circle," and I have found other examples 
since the book was published, such as the German Imperial Circle 
after the fall of the Berlin Wall. (See appendix: "The Prospect of Eu- 
ropean Disintegration.") But there is a danger in pushing the con-

cept oi reflexivity too far, as I nave learned at my owri expefiac. 
There are lohg fallow periods when the movements in financial 
markets do not seem to follow a reflexive tune but rather resemble 
the random walks mandated by the efficient market theory. In 
these circumstances, it is better to do nothing than to pursue a re- 
f lexive hypothesis. 
Treating reflexivity as an intermittent phenomenon rather than 
as a universally valid condition opens up fertile fields for investiga-

tion. For instance, the question poses itself: How can near- and far- 
from-equilibrium conditions be distinguished from each other? 
What is the criterion of demarcation? I have done a lot of thinking 
on that question and I have the beginnings of an answer. Whether

10 Preface 
4 I can formulate it properly remains to be seen in my next book. It 
revolves around a question of values and it is relevant for society in 
general, not only for financial markets. My next book, if it is ever 
written, will be a theory of history, not a theory of finance. I am 
providing an example of how the boom-bust pattern of financial 
markets can be applied to larger historical processes in the ap- 
pendix where I reproduce a lecture I delivered on September 29,

INTRODUCTION 
In a very real sense, this book is my life's work. It touches on 
many of my most abiding interests and it brings together the two 
main strands in my 'intellectual development: one abstract and 
one practical. 
The abstract came' first. Ever since I became conscious of my 
existence I have had a passionate interest in understanding it, and 
1 regarded my own 'understanding as the central problem that 
needed to be understood. To understand oneself-gnote aucton;

nosce te ipsum-is an impossible task. TO achiwe-anythingsL_ 
sembling knowledge we must be abJ~I~-draw a d@in-cti-onebe- v- - -- --- -- tween subject and object; - -- yet in this case the two are the same. 
~hd-one ihinks is part3 what one thinks about; therefore, one's 
thinking lacks an independent pint of referexce by -,=.hich it can 
be judged-it lacks objectivity. 
As an undergraduate I studied economics, but I found eco- 
nomic theory highly unsatisfactory because it failed to come to

grips with th$problem; indeed, it went through great contortions 
to avoid it. Economics seeks to be a science. Science is supposed 
to be objective and it is difficult to be scientific when the subject 
matter, the participant in the economic process, lacks objectivity. 
I was greatly influenced at the time by Karl Popper's ideas on 
scientific method. I accepted most of his views, with one major 
exception. He argued in favor of what he called "unity of

methodH1-that is, the methods and criteria that apply to the 
study of natural phenomena also apply to the study of social 
events. I felt that there was a fundamental difference between the

12 Introduction 
two: the events studied by the social sciences have thinking par- 
t ticipants; natural phenomena do not. The participants' thinking 
creates problems that have no counterpart in natural science. The 
closest analogy is in quantum physics, where scientific observa- 
tion gives rise to Heisenberg's uncertainty principle; but in social 
events it is the participants' thinking that is responsible for the 
element of uncertainty, not the outside observer.

Natural science studies events that consist of a sequence of 
facts. When events have thinking participants, the subject matter 
is no longer confined to facts but also includes the participants' 
perceptions. The chain of causation does not lead directly from 
fact to fact but from fact to perception and from perception to fact. 
This would not create any insuperable difficulties if there were 
I some kind of correspondence or equivalence between facts and

perceptions. Unfortunately, that is impossible because the partic- 
ipants' perceptions do not relate to facts, but to a situation that is 
contingent on their own perceptions and therefore cannot be 
treated as a fact. 
Economic theory tries to sidestep the issue by introducing the 
assumption of rational behavior. People are assumed to act by 
choosing the best of the available alternatives, but somehow the 
distinction between perceived alternatives and facts is assumed

away. The result is a theoretical construction of great elegance 
that resembles natural science but does not resemble reality. It 
relates to an ideal world in which participants act on the basis of 
perfect knowledge and it produces a theoretical equilibrium in 
which the allocation of resources is at an optimum. It has little 
relevance to the real world in which people act on the basis of 
imperfect understanding and equilibrium is beyond rea~h.

The relationship between the participants' understanding and 
the situation in which they participate continued to preoccupy 
me long after I left college. My first priority was to try and make a 
living but in my spare time I wrote a philosophical treatise on the 
subject with the catchy title "The Burden of Consciousness." Un- 
fortunately, the title was the best part of it. By the time I finished, 
I disagreed with my own presentation. I spent three years revising

it. One day I reread what I had written the day before and I could 
not make head or tail of it. It made me realize that I had reached 
a dead end, and I decided to give it up. That was when the prac- 
tical streak in me began to dominate my intellectual development. 
If I had to sum up my practical skills, I would use one word: 
survival. When I was an adolescent, the Second World War gave

Introduction 13 
me a lesson that I have never forgotten. I was fortunate enough to 
have a father who was highly skilled in the art of survival, having 
lived through the Russian revolution as an escaped prisoner of 
war. Under his tutelgge the Second World War served as an ad- 
vanced course at a tender age. As the reader shall see, the invest- 
ment vehicle I created a quarter of a century later drew heavily on 
skills I learned as an ;adolescent.

skills I learned as an ;adolescent. 
After leaving college I had a number of false starts and finally 
became an international arbitrage trader in stocks, first in London 
and then in New York. When the European Common Market was 
formed in 1957, American investors became interested in Euro- 
pean shares, 1 became a security analyst r;bsiaisg Aiiuc~icrnn iirsti- 
tutions on their European investments and for a brief period I 
ruled as a one-eyed king among the blind. My glory came to an

abrupt end when President Kennedy introduced a so-called inter- 
est equalization tax which effectively stopped purchases of for- 
eign securities. I decided to put my money-making activities on 
the back burner and spent three years, from 1963 to 1966, revising 
"The Burden of Consciousness." 
When I finally decided to return to the land of the living I 
started a model portfolio that became a hedge fund (a mutual fund 
that employs leverage and uses various techniques of hedging) in

1969. I have been in charge of that fund ever since, although I 
delegated much of the responsibility to others between September 
1981 and September 1984. The fund has growhom about $4 
million at inception to nearly $2 billion and most of the growth 
has been internally generated. Original investors have seen the 
value of their shares mulitiply 300-fold. No investment fund has 
ever prodsced comparable results, 
In the first ten years of my business career I had not much use

for anything I had learned in college and there was an almost total 
separation between my practical activities and my theoretical in- 
terests. Selling and trading in securities was a game I played with- 
out putting my true self on the line. 
All this changed when I became a fund manager. I was putting 
my money where my mouth was and I could not afford to disso- 
ciate myself from my investment decisions. I had to use all my 
intellectual rasources and I discovered, to my great surprise and

gratification, that my abstract ideas came in very handy. It would 
be an exaggeration to say that they accounted for my success; but 
there can be no doubt that they gave me an edge. 
I developed my own peculiar approach to investing, which was

14 Introduction 
at loggerheads with the prevailing wisdom. The generally ac- . ' cepted view is that markets are always right-that is, market 
prices tend to discount future developments accurately even 
when it is unclear what those developments are. I start with the 
opposite point of view. I believe that market prices are always 
wrong in the sense that they present a biased view of the future. 
But distortion works in both directions: not only do market par-

ticipants operate with a bias, but their bias can also influence the 
course of events. This may create the impression that markets 
anticipate future developments accurately, but in fact it is not 
present expectations that correspond to future events but future 
ents that are sha~ed by prose~t expect~?fons. The psrticipants' t 
rceptions are inherently flawed, and there is a two-way connec- 
I tion between flawed perceptions and the actual course of events,

which results in a lack of correspondence between the two. I call 
this two-way connection "reflexivity." 
In the course of my investment activities, I discovered that fi- 
nancial markets operate on a principle that is somehow akin to 
scientific method. Making an investment decision is like formu- 
lating a scientific hypothesis and submitting it to a practical test. 
The main difference is that the hypothesis that underlies an in-

vestment decision is intended to make money and not to establish 
a universally valid generalization. Both activities involve signifi- 
cant risk, and success brings a corresponding reward-monetary 
in one case and scientific in the other. Taking this view, it is 
possible to see financial markets as a laboratory for testing hy- 
potheses, albeit not strictly scientific ones. The truth is, success- 
ful investing is a kind of alchemy.

ful investing is a kind of alchemy. 
Most market participants do zot view ~ll,arketb iii this ligC:. That 
means that they do not know what hypotheses are being tested; it 
also means that most of the hypotheses that are submitted to mar- 
ket testing are quite banal. Usually they amount to nothing more 
than the assertion that a particular stock is going to outperform 
the market averages. 
I had a certain advantage over other investors because at least I

had an idea about the way financial markets operate. I would be 
lying, however, if I claimed that I could always formulate worth- 
while hypotheses on the basis of my theoretical framework. 
Sometimes there were no reflexive processes to be found; some- 
times I failed to find them; and, what was the most painful of all, 
sometimes I got them wrong. One way or another, I often invested

without a worthwhile hypothesis and my activities were not very 
different from a random walk. But I was attuned to reflexive pro- 
cesses in financial markets and my major successes came from 
exploiting the opportunities they presented. 
My approach to the market was not as abstract as it sounds. It 
took an intensely pArsonal, emotional form: testing was closely 
associated with pain ;and success with relief. When I asserted that

"markets are always biased" I was giving expression to a deeply 
felt attitude: I had a very low regard for the sagacity of profes- 
sional investors and the more influential their position the less I 
considered them capable of making the right decisions. My part- 
ner and 1 taoltl ; malielous plsasure in makhg rnoriey by selling 
short stocks that were institutional favorites. But we differed in 
our attitudes to our own activities. He regarded only the other

participants' views as flawed, while I thought that we had as good 
a chance of being wrong as anyone else. The assumption of inher- 
ently flawed perceptions suited my self-critical attitude. 
Operating a hedge ;fund utilized my training in survival to the 
fullest. Using leverage can produce superior results when the 
going is good, but it can wipe you out when events fail to conform 
to your expectations: One of the hardest things to judge is what

level of risk is safe. There are no universally valid yardsticks: each 
situation needs to be judged on its own merit. In the final analysis 
you must rely on your instincts for survival. Thus my engagement 
in running a hedge fund brought together both my abstract inter- 
ests and my practical skills. 
I did not play the financial markets according to a particular set 
of rules; I was always more interested in understanding the 
changes that cccur in the rules of the game. I started with hy-

potheses relating to individual companies; with the passage of 
time my interests veered increasingly toward macroeconomic 
themes. This was due partly to the growth of the fund and partly 
to the growing instability of the macroeconomic environment. For 
instance, exchange rates were fixed until 1973; subsequently, they 
became a fertile field for speculation. 
For the past four or five years I have had a growing sense of 
impending financial disaster. I felt that a long-lasting expansion-

ary cycle was becoming increasingly unsound and unsustainable 
and we were getting ready for a bust. That was one of the reasons 
I distanced myself from the active management of the fund in 
1981 and reduced its overalflevel of exposure. My interest shifted

16 Introduction 
from my own survival to the survival of the system. I made a I study of the international debt problem and published some pa- 
pers on the subject. I used the same theoretical framework as in 
my investment activities and my analysis was not without merit. 
Unfortunately, the more complex the system, the greater the room 
for error. I made some mistakes in my analysis that detracted from 
the accuracy of my predictions; they also had a detrimental effect

on my investment results until I revised my views in the course 
of writing this book. 
The more successful I had been in applying my ideas in finan- 
cial markets, the keener I became to express them in theoretical 
form. I ~u~~tiimed t~i ~Eeikh the Iarrtasy that the concept of ref"lr;x- 
ivity constitutes a major contribution to our understanding of the 
4 world in which we live. I believed that the participants' bias is 
the key to an understanding of all historical processes that have

thinking participants, just as genetic mutation is the key to biolog- 
ical evolution. But a satisfactory formulation of the theory of re- 
flexivity continued to elude me. I always ran into trouble when I 
tried to define what I meant by the imperfect understanding of the 
participants. To speak accurately of a distortion we must know 
what the situation would be if it were not distorted by the partic- 
ipants' perceptions. Unfortunately that does not seem possible

because the participants' thinking is an integral part of the situa- 
tion they have to think about. It is not surprising that the concept 
of reflexivity should present extreme difficulties; if it were an 
easier concept to work with, economists and other social scien- 
tists would not have gone to such lengths to banish it from their 
subject matter. 
This book is a finel. attempt to expiore the i~~iplications of re- 
flexivity. I have tried to circumvent the difficulties I encountered

in the past by approaching the subject from the opposite direc- 
tion. Instead of getting bogged down in abstract theory, I am going 
to draw on my experimental, practical findings to the greatest 
possible extent. I cannot avoid an abstract discussion altogether, 
but I have confined it to a single chapter. In exploring the practi- 
cal implications, I start with the simplest cases and gradually lead 
up to more complex ones. This approach happens to coincide

with the historical order in which 1 encountered reflexive devel- 
opments in practice: first the stock market, then the currency mar- 
ket, then the international debt problem, and finally what may be 
called the credit cycle.

Introduction 17 
The stock market provides some pure examples of a boom and 
bust pattern; freely floating currency rates allow me to explore 
well-formed wave patterns. The boom and bust in international 
bank lending is part pf a more complex, historical process of 
credit expansion and eventual credit contraction. It has given rise 
to the configuration that I have dubbed "Reagan's Imperial Cir- 
cle." The configuratioq prevailed from the international debt cri-

sis of 1982 until the first half of 1985 but it was inherently 
unstable. How the instability will be resolved is one of the main 
questions considered in this book. 
The experimental approach has borne unexpected results. I 
mads two major discavsries in the courss of writiiig: one is a I 
reflexive connection between credit and collateral; the other is a 
reflexive relationship between the regulators and the economy 
they regulate. 
It has long been asshmed that monetary values are a passive

reflection of the state of affairs in the real world. Classical eco- 
nomics focused on the real world and neglected the problems 
connected with money and credit; even Keynes couched his gen- 
eral theory in real terms. Monetarists sought to stand the relation- 
ship on its head: they kgue that it is possible to control inflation 
by controlling the growth of the money supply. 
In my opinion, all 'these views are based on a fundamental

misconception. Money values do not simply mirror the state of 
affairs in the real world; valuation is a positive actqhat makes an 
impact on the course of events. Monetary and real phenomena are 
connected in a reflexive fashion; that is, they influence each other 
mutually. The reflexive relationship manifests itself most clearly 
ir, the use ~nd abuse ol credit. 
Loans are based on the lender's estimation of the borrower's

ability to service his debt. The valuation of the collateral is sup- 
posed to be independent of the act of lending; but in actual fact 
the act of lending can affect the value of the collateral. This is true 
of the individual case and of the economy as a whole. Credit 
expansion stimulates the economy and enhances collateral val- 
ues; the repayment or contraction of credit has a depressing influ- 
ence both on the economy and on the valuation of the collateral.

The connection between credit and economic activity is anything 
but constant-for instance, credit for building a new factory has 
quite a different effect from credit for a leveraged buyout. This 
makes it difficult to quantify t& connection between credit and

18 Introduction 
economic activity. Yet it is a mistake to ignore it. The monetarist 
4 school has done so, with disastrous consequences. 
The reflexive interaction between the act of lending and collat- 
eral values has led me to postulate a pattern in which a period of 
gradual, slowly accelerating credit expansion is followed by a 
short period of credit contraction-the classic sequence of boom 
and bust. The bust is compressed in time because the attempt to

liquidate loans causes a sudden implosion of collateral values. 
Economic history has been punctuated by booms and busts. 
Nevertheless, the concept of a credit cycle is too simplistic to 
explain the course of events. For one thing, the connection be- 
!wee~ credit and sson~mic activity is too tenuous and variable to 
yield a regular pattern. For another, the sequence of events is 
I greatly complicated by the influence of economic policy. Periodic

busts have been so devastating that strenuous efforts have been 
made to prevent them. These efforts have led to the evolution of 
central banking and of other mechanisms for controlling credit 
and regulating economic activity. 
To understand the role of the regulators it must be realized that 
they are also participants: their understanding is inherently im- 
perfect and their actions have unintended consequences. The re- 
lationship between the regulators and the economy is reflexive

and it also exhibits cyclical characteristics in the sense that it 
tends to swing from one extreme to another. 
What is the connection between the regulatory cycle and the 
credit cycle? At this point, my views become very tentative. I 
believe that the two cycles broadly overlap in time, that the min- 
imum of regulations tends to coincide with the maximum of 
credit expansion and vi~e versa. But within this chronological 
coincidence there is constant interaction between the two cycles

that influences the shape and duration of both. The interaction 
between the two cycles yields a unique path that cannot be fitted 
into any regular or repetitive pattern. 
I have tried to apply this complex and tentative framework to 
an interpretation of recent economic and financial history. Need- 
less to say, a great many factors come into play; but my focus is 
on the twin cycles in credit and regulation. The main topics I deal

with are the transformation of banking from a highly regulated to 
a less regulated industry, the boom and bust in international lend- 
ing, mergermania, and international capital movements. 
Until 1982, the story is a fairly straightforward case of boom

Introduction 19 
and bust, but after 1982 the situation gets very complicated. If 
events had been allo&d to take their course, the uncontrolled 
credit expansion of the 1970s would have come to an unhappy 
end; but exactly becauae the consequences would have been so 
disastrous, the financial authorities came to the rescue and suc- 
cessfully avoided a bust. Since then, we have been passing 
through uncharted waters. The great boom exhausted itself some

time ago but its life span has been extended by artificial means in 
order to avoid a great bust. 
I try to trace the unique path that events have taken: the pres- 
ervation of the accumulated burden of bad international debt 
through the formation cf what I call the "Collective" system of 
lending and the emergence of the United States government as 
the "borrower of last resort." Both of these are unprecedented 
developments. They gave rise to this strange constellation that I

have called the Imperial Circle: a benign circle at the center and a 
vicious circle at the periphery of a worldwide system based on a 
strong dollar, a strong ;US. economy, a growing budget deficit, 
a growing trade deficit, and high real interest rates. The Imperial 
Circle held the international economic and financial system to- 
gether but it was inherently unstable because the strong dollar 
and high real interest rates were bound to outweigh the stimulat-

ing effect of the budget deficit and weaken the U.S. economy. The 
Imperial Circle could not last indefinitely. What would happen 
next? X 
To answer that question, I conducted an experiment from Au- 
gust 1985 onward. In effect, I kept a diary in which I recorded the 
thoughts that went into my investment decisions on a real-time 
hsis. Since I c~nsidered the future of the Imperial Circle of park- 
mount importance, the experiment served as a test of my ability

to predict the future course of events, using the framework devel- 
oped in the book. The experiment was a roaring success in finan- 
cial terms-my fund never did better. It also produced a 
surprising result: I came out of the experiment with quite differ- 
ent expectations about the future. 
I started with the presumption that the benign circle was in 
danger of reversing itself: a weak dollar and a weak economy 
would combine to keep interest rates higher than they ought to

be, and without any scope for further monetary or fiscal stimulus 
the decline of both the economy and the dollar would become 
irreversible. But the situation was once again saved by the inter- \

2 0 Introduction 
vention of the monetary authorities. By changing from a system 
+ of freely floating exchange rates to a "dirty float," the decline of 
the dollar was cushioned, and, with the help of lower interest 
rates and booming financial markets, the economy was prevented 
from slipping into recession. We entered a new phase which I 
describe, with only a modicum of irony, as the "Golden Age of 
Capitalism." 
It can be seen that this book seeks to accomplish a number of

things at the same time. It propounds not just one general theory 
-the theory of reflexivity-but also another specific theory, that 
of a credit-cum-regulatory cycle. The latter idea is so tentative 
that it hardly qualifies as a theory. Yet I try != apijly it zot ~aly to 
explain contemporary history but also to predict the outcome, 
t and in the course of doing so I provide a practical demonstration 
of the fundamental difference between explaining and predicting

reflexive phenomena. I also try to draw some general conclusions 
from the analysis. The most important ones are, first, that it is 
credit that matters, not money (in other words, monetarism is a 
false ideology), and, second, that the concept of a general equilib- 
rium has no relevance to the real world (in other words, classical 
economics is an exercise in futility). Financial markets are inher- 
ently unstable; that leads to a third conclusion that is better stated

as a question than an assertion: what policy measures are needed 
to reestablish the stability of our economic system? 
The book would be easier to read if it tried to make just one 
point at a time. Unfortunately, that is not possible, because the 
various points are interconnected. If the theory of reflexivity were 
widely known, I could have taken it for granted and concentrated 
on an exploration of +&e credit and regulat~ry cycles. Si~~iiarly, if

the fact that financial markets are inherently unstable were gen- 
erally recognized, I need not have spent so much time on dem- 
onstrating that the concept of equilibrium as used in economic 
theory is totally unrealistic. As it is, I had to try to make several 
points more or less simultaneously. 
To make matters worse, the book does not qualify as a finished 
product. When I started writing it, I thought I had a theory of

reflexivity to present and my difficulties related only to its presen- 
tation. As I tried to apply the theory to various situations, I dis- 
covered that I do not actually have a well-formed theory. The idea 
that the participants' biases play an important causal role in his- 
torical events is both valid and interesting, but it is too general to

Introduction 21 
qualify as a theory that can help to explain and predict the course 
of events. The boomhust pattern I have established applies to 
some developments but not to others. To try to fit every initially 
self-reinforcing and eyentually self-defeating development into 
its mold can give rise, to serious distortions. I feel like the early 
astronomers who tried to describe the elliptical paths of the 
planets in terms of circles and semicircles; the only difference is

that the path of reflexibe events is irregular to start with. 
My fantasy was to present a general theory of reflexivity that 
would explain the great bust of the 1980s in the same way that 
Keynes's General Theory of Employment, Interest and Money ex- 
plained the Great Depression sf ihz 1330s. As it tr;rns or;:, wa do 
not have a great bust and I do not have a general theory. What I 
have is an approach that can help to illuminate the present pre-

carious state of our financial system. It cannot explain and predict 
the course of events in the manner to which we have become 
accustomed during our long love affair with natural science for 
the simple reason that reflexive processes cannot be explained 
and predicted in that Aanner. A different approach is needed and 
this book is an attempt to develop one. It is best regarded as part 
of a process of discoveky rather than the finished product.

All this makes for a difficult, dense book, although I can prom- 
ise the reader that nothing in the rest of the book is quite as dense 
as this introduction. I explore a complex subject. I bring a com- 
plex mind to bear on it. I can argue in my defensethat the com- 
plexity of my thinking mirrors the complexity of the financial 
markets rather well, as demonstrated by the financial outcome 
of the real-time experiment. There is, therefore, at least a prima

facie case fcrr giving me 3 hearicg. I shall t-ry ncii to abuse the pdv- 
ilege. 
It may be helpful if I sketch out the structure of the book. Part I 
propounds the theory, The first chapter deals with the concept of 
reflexivity in general terms and explores the difficulties in under- 
standing reflexive phenomena. In particular, it argues that the 
symmetry between explanation and prediction that characterizes 
the laws of natural science is not attainable. The next three chap-

ters apply the theory to the financial markets: Chapter 2 to the 
stock market and Chapter 3 to the currency market, with Chapter 
4 outlining a credit and regulatory cycle. 
Part I1 seeks to explain contemporary economic and financial 
history using the hypotheses outlined in Chapter 4. The history

2 2 Introduction 
is, of necessity, selective, concentrating on those developments 
4 that are relevant to the concept of a credit and regulatory cycle. 
My main topics are banking, international lending, and merger- 
mania. 
Part I11 consists of a real-time experiment which is both test and 
prediction at the same time. As a test it does not qualify as a 
scientific one by the standards of natural science; but it may serve 
as an example of how theories about reflexive developments can

be tested. 
Part IV evaluates the results of the real-time experiment. Chap- 
ter 15 explores the scope for what I provocatively call alchemy. 
0. The real-time experiment can be regarded zs. sr, zxercisa in =nor?_ 
cia1 alchemy. Chapter 16 examines the limitations of social sci- 
t ence. 
Part V seeks to provide some prescriptions for economic policy. 
Chapter 17 examines the relative merits of free markets and regu- 
lation, and Chapter 18 argues in favor of an international central

bank. Since both the market mechanism and the attempts to reg- 
ulate it are inherently flawed, it may be argued that all attempts 
at systemic reform are doomed to failure. I reject that argument in 
Chapter 19. 
In the Epilogue I explore the implications of the concept of 
reflexivity outside the sphere of finance and in a final flight of 
fancy I attempt to provide my own answers to some age-old meta- 
physical questions. 
Since my thinking has evolved in the course of writing, it may

be helpful for the reader to know when the various chapters were 
written. The first part of the book was completed before I em- 
barked on the real-time experiment in, Aug~st 1985. Mcreovei, 
Chapters 5-9, which deal with recent history, preceded in time 
Chapter 4, which outlines the concept of the credit and regulatory 
cycle. Chapter 4 incorporates discoveries I made in the course of 
writing; that is why it is so tentative in character.

I should like to emphasize that this book is not meant to pro- 
vide a practical guide to getting rich in the stock market. Most of 
what 1 know is in the book, at least in theoretical form. I have not 
kept anything deliberately hidden. But the chain of reasoning 
operates in the opposite direction: I am not trying to explain how 
to use my approach to make money; rather, I am using my expe- 
riences in the financial markets to develop an approach to the

Introduction 2 3 
study of historical processes in general and the present historical 
moment in particulai. If I did not believe that my investment 
activities can serve that purpose, I would not want to write about 
them. As long as I am actively engaged in business, I would be 
better off to keep theq a trade secret. But I would value it much 
more highly than any'business success if I could contribute to an 
understanding of the~world in which we live or, better yet, if I

could help to preserve the economic and political system that has 
allowed me to flourish as a participant.

THE THEORY OF REFLEXIVITY 
Economic theory is devoted to the study of equilibrium positions. 
The concept of an equilibrium is very useful. It allows us to focus 
on the final outcome rather than on the process that leads up to 
it. But the concept is also very deceptive. It has the aura of some- 
thing empirical: since the adjustment process is supposed to lead 
to an equilibrium, an equilibrium position seems somehow im- 
plicit in our observations. That is not true. Equilibrium itself has

rarely been observed in real life-market prices hwe a notorious 
habit of fluctuating. The process that can be observed is supposed 
to move toward an equilibrium. Why is it that the equilibrium is 
never reached? It is true that market participants adjust to market 
prices Llit they may be adjusting to a constaxitly moving talgei. In 
that case, calling the participants' behavior an adjustment process 
may be a misnomer and equilibrium theory becomes irrelevant to 
the real world.

the real world. 
Equilibrium is the product of an axiomatic system. Economic 
theory is constructed like logic or mathematics: it is based on 
certain postulates and all of its conclusions are derived from them 
by logical manipulation. The possibility that equilibrium is never 
reached need not invalidate the logical construction, but when a 
hypothetical equilibrium is presented as a model of reality a sig- 
nificant distortion is introduced. If we lived in a world in which

the angles of a triangle did not add up to 180 degrees, Euclidean 
geometry would constitute such a misleading model.

28 Theory 
The crowning achievement of the axiomatic approach is the 
theory of perfect cgmpetition. Although it was first propounded 
nearly two hundred years ago, it has never been superseded; only 
the method of analysis has been refined. The theory holds that 
under certain specified circumstances the unrestrained pursuit of 
self-interest leads 40 the optimum allocation of resources. The 
equilibrium point is reached when each firm produces at a level

where its margina1;cost equals the market price and each con- 
sumer buys an amount whose marginal "utility" equals the mar- 
ket price. Analysis shows that the equilibrium position 
maximizes the benefit of all participants, provided no individual 
buyer or seller can ihfluence market prices. It is this line of argu- 
ment thaihas served as the theoretical underpinning for the lais- 
sez-faire policies of the nineteenth century, and it is also the basis

of the current belief in the "magic of the marketplace." 
Let us examine the main assumptions of the theory of perfect 
competition. Those that are spelled out include perfect knowl- 
edge; homogeneous ,and divisible products; and a large enough 
number of participarjts so that no single participant can influence 
the market price. 
The assumption of perfect knowledge is suspect because under- 
standing a situation in which one participates cannot qualify as

knowledge. That was the assumption that I found so unacceptable 
as a student. I have Lo doubt that classical economists used the 
assumption in exactly that sense in which I found it objectionable 
because nineteenth-century thinkers were less aware of the limi- 
tations of knowledge than we are today. As the epistemological 
problems began to surface, exponents of the theory found that 
they could get by using a more modest word: inforrrlction. In its

modern formulation the theory merely postulates perfect infor- 
mation.' 
Unfortunately, this assumption is not quite sufficient to support 
the construction of the theory. To make up for the deficiency, 
modern economists resorted to an ingenious device: they insisted 
that the demand and supply curves should be taken as given. 
They did not present this as a postulate; rather, they based their 
claim on methodological grounds. They argued that the task of

economics is to study the relationship between supply and de- 
mand and not either by itself. Demand may be a suitable subject 
for psychologists, supply may be the province of engineers or 
management scientists; both are beyond the scope of  economic^.^ 
Therefore, both must be taken as given.

The Theory of Reflexivity 29 
Yet, if we stop to ask what it means that the conditions of 
I supply and demand are independently given, it is clear that an 
additional assumption has been introduced. Otherwise, where 
would those curves come from? We are dealing with an as- 
sumption disguised as a methodological device. Participants 
are supposed to choose between alternatives in accordance 
with their scale of preferences. The unspoken assumption is that

the participants know what those preferences and alternatives 
are. 
As I shall try to show, this assumption is untenable. The shape 
of the supply and demand curves cannot be taken as indepen- 
dently given, because both of them incorporate the participants' 
expectations about events that are shaped by their own expecta- 
I tions. 
Nowhere is the role of expectations more clearly visible than in 
financial markets. Buy and sell decisions are based on expecta-

tions about future prices, and future prices, in turn, are contingent 
on present buy and sell decisions. To speak of supply and de- 
mand as if they were determined by forces that are independent 
of the market participants' expectations is quite misleading. The 
situation is not quite so clear-cut in the case of commodities, 
where supply is largely dependent on production and demand on 
consumption. But the price that determines the amounts pro-

duced and consumed is not necessarily the present price. On the 
contrary, market participants are more likely to be guided by fu- 
ture prices, either as expressed in futures marketg or as antici- 
pated by themselves. In either case, it is inappropriate to speak of 
independently given supply and demand curves because both 
curves incorporate the participants' expectations about future 
prices. 
The very idea that events in the marketplace may affect the

shape of the demand and supply curves seems incongruous to 
those who have been reared on classical economics. The demand 
and supply curves are supposed to determine the market price. If 
they were themselves subject to market influences, prices would 
cease to be uniquely determined. Instead of equilibrium, we 
would be left with fluctuating prices. This would be a devastating 
state of affairs. All the conclusions of economic theory would lose 
their relevance to the real world.

their relevance to the real world. 
It is to prevent this outcome that the methodological device that 
treats the supply and demand curves as independently given was 
introduced. Yet there is something insidious about using a meth-

30 Theory 
odological device to obscure an assumption that would be unten- 
able if it were spelled out. To preserve the integrity of economic 
theory as an axiomatic system, its assumptions ought to be ex- 
plicitly stated. We may then conclude that economic theory is no 
more relevant to the real world than non-Euclidean geometry, but 
at least we would know where we stand. Instead, we have been 
deceived by a methodological subterfuge. The demand and sup-

ply curves are prpsented in textbooks as though they were 
grounded in empirical evidence. But there is scant evidence for 
independently given demand and supply curves. Anyone who 
trades in markets where prices are continuously changing knows 
that participants are very much influenced by market develop- 
ments. Rising prices ~jfteil ditraci buyers and vice versa. How 
could self-reinforcing trends persist if supply and demand curves

were independent of market prices? Yet, even a cursory look at 
commodity, stock, and currency markets confirms that trends are 
the rule rather than )he exception. 
The theory of perfect competition could be defended by arguing 
that the trends we can observe in commodity and financial mar- 
kets are merely temporary aberrations which will be eliminated 
in the long run by the "fundamental" forces of supply and de- 
mand. It should be remembered that the theory of perfect compe-

tition does not claim to define the path of adjustment; it merely 
analyzes the situation after all the adjustments have taken place. 
The trouble with the argument is that there can be no assurance 
that "fundamental" forces will correct "speculative" excesses. It 
is just as possible that speculation will alter the supposedly fun- 
damental conditions of supply and demand. 
In the normal course of events, a speculative price rise provokes

countervailing forcss: suppiy is increased and demand reduced, 
and the temporary excess is corrected with the passage of time. 
But there are exceptions. In foreign exchange, for example, a sus- 
tained price movement can be self-validating, because of its im- 
pact on domestic price levels. The same is true in the stock market 
where the performance of a stock may affect the performance of 
the company in question in a number of ways. And in examining

the recent history of international lending we shall find that ex- 
cessive lending first increased the borrowing capacity of debtor 
countries, as measured by their debt ratios, and then, when the 
banks wanted to be repaid, the debtor countries' ability to do so 
evaporated. Generally speaking, we shall find that the expansion

The Theory of Reflexivity 31 
and contraction of credit can affect the debtors' ability and will- 
I ingness to pay. 
Are these exceptions that confirm the rule, or do they necessi- 
tate a revision of accepted theory? The answer depends on the 
frequency and severity of their occurrence. If we are dealing with 
an isolated instance, we can treat it as a paradox; but if one inci- 
dent follows another, we must question the theory.

I contend that such paradoxical behavior is typical of all finan- 
cial markets that serve as a discounting mechanism for future 
developments, notably stock markets, foreign exchange markets, 
banking, and all forms of credit. Microeconomic theory may 
continue to ignore it, because there are large areas of economic 
activity where it occurs only occasionally or not at all; b&-we 
I cannot expect to understand macroeconomic developments with-

out taking the phenomenon into account. A world of fluc- 
tuating exchange rates and large-scale capital movements is 
characterized by vicious and benign circles in which the "nor- 
mal" pattern of causation, as defined by classical economics, 
seems to be reversed: market developments dictate the evolu- 
tion of the conditions of supply and demand, not the other way 
around. 
If the process of adjustment does not lead to an equilibrium,

what happens to the conclusions of economic theory? The answer 
is that they remain valid as deductions but they lose their rele- 
vance to the real world. If we want to understand the real world, 
we must divert our gaze from a hypothetical fins outcome and 
concentrate our attention on the process of change that we can 
observe all around us. 
This will require a radical shift in our thinking. A process of 
change is much more difficult to understand than a static equilib-

rium. We shall have to revise many of our preconceived ideas 
about the kind of understanding that is attainable and satisfy our- 
selves with conclusions that are far less definite than those that 
economic theory sought to provide. 
The Problem of Imperfect Understanding 
The understanding of the actual course of events, as distinct from 
a hypothetical equilibrium, poses problems that have not been 
properly appreciated. The problems arise because participants

32 Theory 
base their decisions on an inherently imperfect understanding of 
the situation in which they participate. There are two related sets 
4 of problems to be considered: the imperfect understanding of the 
participant and the imperfect understanding of the social scien- 
tist. We must be careful not to confuse the two. 
In this section I shall try to explain why the participants' un- 
derstanding is inherently imperfect. In the next section I shall

examine why the imperfect understanding of the participants 
poses difficulties for the social sciences. 
The imperfect understanding of the participant is a difficult 
concept to define and an even more difficult one to work with. I 
shall try to approach it by comparing the position of the partici- 
pant vlth that of ;. naturdl scientist. (4 have to specify a natural 
scientist, because social scientists are confronted with special

problems arising out of the imperfect understanding of partici- 
pants. These will be dealt with in the next section.) The purpose 
of the comparison is to establish a standard in terms of which the 
understanding of the participant can be called imperfect. What 
makes the comparison tricky is that the natural scientist is not 
capable of perfect understanding either. Far from it. As Karl Pop- 
per has shown,3 it is a cardinal principle of scientific method that

perfect knowledge is not attainable. Scientists work by constantly 
testing plausible hypotheses and propounding new ones. If they 
did not treat all conclusions as provisional and subject to im- 
provement, natural science could not have reached its present 
state of development and it could not progess any further. Al- 
though it is far from perfect, the knowledge attained by natural 
scientists provides a standard in terms of which the participants' 
understanding can be called imperfect.

understanding can be called imperfect. 
Natural scie~tfsts have oue great advantage over participants: 
they deal with phenomena that occur independently of what any- 
body says or thinks about them. The phenomena belong to one 
universe, the scientists' statements to another. The phenomena 
then serve as an independent, objective criterion by which the 
truth or validity of scientific statements can be judged. Statements 
that correspond to the facts are true; those that do not are false.

To the extent that the correspondence can be established, the 
scientist's understanding qualifies as knowledge. We do not need 
to go into the various difficulties that stand in the way of estab- 
lishing the correspondence. The important point is that scientists 
have an objective criterion at their disposal.

The Theory of Reflexivity 3 3 
By contrast, the situation to which the participants' thinking 
relates is not independently given: it is contingent on their own 
decisions. As an objective criterion for establishing the truth or 
validity of the participants' views, it is deficient. It does provide 
a criterion of sorts: some expectations are validated by subsequent 
events, others are not: But the process of validation leaves some-

thing to be desired: one can never be sure whether it is the expec- 
tation that corresponds to the subsequent event or the subsequent 
event that conforms to the expectation. The segregation between 
thoughts and events that prevails in natural science is simply 
missing. 
Thinking plays a dual role. On the one hand, participants seek 
to understand the situation in which they participate; on the 
other, their understanding serves as the basis of decisions which

influence the course of events. The two roles interfere with each 
other. Neither role is 'performed as well as it could be if it were 
performed separately. If the course of events were independent of 
the participants' decisions, the participants' understanding could 
equal that of a naturbl scientist; and if participants could base 
their decisions on knowledge, however provisional, the results of 
their actions would have a better chance of corresponding to their

intentions. As it is, participants act on the basis of imperfect un- 
derstanding and the course of events bears the imprint of. that 
imperfection. 
In a milder form, the lack of separation betwmn the subject 
matter and the act of thinking may also arise in natural science. 
The most celebrated example is in quantum physics where the 
act of observation interferes with the observed phenomenon. It 
has given rSss to Heisenberg's uncertainty principle which, in

effect, establishes a limit to the scientist's ability to attain knowl- 
edge. But in natural science the problem occurs only at the limit, 
whereas for the participant it is at the very center of his thinking. 
For one thing, the scientist makes a deliberate attempt not to 
interfere with his subject matter, whereas the participant's pri- 
mary purpose is to mold the situation in which he participates to 
his own satisfaction. More important, in quantum physics it is

only the act of observation which interferes with the subject mat- 
ter, not the theory of uncertainty, whereas in the case of thinking 
participants their own thoughts form part of the subject matter to 
which they relate. The positive accomplishments of natural sci- 
ence are confined to the area where thinking and events are effec-

34 Theory 
tively segregated. When events have thinking participants that 
area shrinks to the vanishing point. 
The Problem of the Social Sciences 
We are now in a position to examine the problems of the social 
sciences. Again, there are two distinct issues to be considered. 
One relates to the subject matter, the other to the observer. 
Scientific method is designed to deal with facts; but, as we have 
seen, events which have thinking participants do not consist of

facts alone. The participant's thinking plays a causal rda, ye; i1 
does not correspond to the facts for the simple reason that it does 
not relate to facts. Participants have to deal with a situation that 
is contingent on their own decisions; their thinking constitutes 
an indispensable ingredient in that situation. Whether we treat it 
as a fact of a special kind or something other than a fact, the 
participants' thinking introduces an element of uncertainty into

the subject matter. This element is absent in the natural sciences. 
As we have seen, there is some similarity between the uncertainty 
introduced by the participants' thinking and Heisenberg's uncer- 
tainty principle in quantum physics but, as we shall soon see, the 
parallel is misleading. 
Now for the role of the scientific observer: it is much easier to 
maintain the required segregation between facts and statements 
when the subject matter itself does not contain any statements,

observations, or thoughts of any kind. 
Most discussions about the shortcomings of the social sciences 
have focused on the second issue. Expressioris like "self-fulf lling 
prophecies" or "self-defeating experiments" are widely used 
but usually they relate to the would-be scientist. Yet it is the 
self-influencing character of the participants' thinking that is re- 
sponsible for the element of uncertainty (or indeterminacy) I men-

tioned before. The difficulties of scientific observation pale into 
insignificance when compared with the indeterminacy of the sub- 
ject matter. The indeterminacy would remain even if all the prob- 
lems relating to the observer were resolved, whereas the problems 
of the observer can be directly attributed to the indeterminacy of 
the subject matter. Thus the problem of the social sciences is not 
merely methodological but inherent in the subject matter.

The Theory of Reflexivity 3 5 
be attributed to the false analogy with Heisenberg's uncertainty 
principle. I am no expert in quantum physics but, as I understand 
it, the principle holds that the mass and velocity of quantum 
particles cannot be measured at the same time because the act of 
measurement interfergs with the object that is being measured. In 
this case, the element* of uncertainty is introduced by the outside 
observer. (Whether tlje behavior of quantum particles is inher-

ently random is a separate question.) The parallel with the social 
sciences is misleading because in the latter case the indetermi- 
nacy (uncertainty) is caused by the partikipants. Only if quantum 
particles behaved as' thinking participants would the analogy 
hold. 
I shall try to reverse the discussion to its proper order: the 
uncertainty in the subject matter first, the role of the scientist 
second. 
The idea that there' is a fundamental difference in the subject

matter of the natural sand social sciences has not been generally 
recognized. On the ccjntrary, Karl Popper, whom I otherwise ad- 
mire, enunciated what he called the "doctrine of the unity of 
~cience";~ that is, the same methods and criteria apply in both the 
natural and social sciences. Although it has not been universally 
accepted, it has not been conclusively refuted either. 1 shall try to 
do so here. 
In order to appreciate the problem posed by thinking partici-

pants, let us take a closer look at the way scientifi95 method oper- 
ates. For this purpose I am invoking Karl Popper's scheme of 
scientific method, described in technical terms as the "deductive- 
nomological," or "D-N," model. Like every model, it presents a 
simplified and idealized version of a more comi;lex reiility, but 
exactly because it is simple and elegant it suits my purpose very 
well. 
The model is built on three kinds of statements: specific initial

conditions, specific final conditions, and generalizations of uni- 
versal validity. Combining a set of generalizations with known 
initial conditions yields predictions; combining them with 
known final conditions provides explanations; and matching 
known initial with known final conditions serves as testing for 
the generalizations involved. It can be seen that there is a sym- 
metry between predictions and explanations; they are logically

reversible. Testing is different, because no amount of testing can 
prove that a generalization is universally valid. Scientific theories

36 Theory 
can only be falsified, never verified. The asymmetry between 
verification and falsification and the symmetry between predic- 
tion and explanation are the two crucial features of Popper's 
scheme. 
The model works only if certain conditions are fulfilled. An 
essential condition is that the content of the statements should 
exist in total isolation from the statements that are made about 
them; only then does the content provide an independent crite-

rion for judging the truth or validity of the statements that relate 
to it.* Other essential requirements are that the initial and final 
conditions should consist of facts which are amenable to scien- 
tific observation and the generalizations should, have universal 
validity. That is, if a given set of conditions recurred, it would 
have to be followed or preceded by the same set of conditions as 
before. It can be seen that the requirement of universal validity

defines not only the nature of scientific laws but also the character 
of initial and final conditions: they must consist of observable 
facts governed by universal laws. It is this requirement that is so 
difficult to meet when a situation has thinking participants. 
What constitutes scientific observation is a matter of debate that 
we need not enter into here. Clearly, a single observation by a 
single scientist is not admissible. Exactly because the correspon-

dence between facts and statements is so difficult to establish, 
science is a collective enterprise where the work of each scientist 
has to be open to control and criticism by others. 
The interaction between scientists is governed by certain con- 
ventions. These conventions are neither clearly defined nor per- 
manently fixed. They derive their authority from the fact that fiey 
produce desired results. Individual scientists often find the con-

ventions quite onerous and try various shortcuts in order to attain 
a desired result. Only because the shortcuts do not work do the 
conventions of scientific method continue to prevail. 
Perhaps the most outstanding example of the observer trying to 
impose his will on his subject matter is the attempt to convert 
base metal into gold. Alchemists struggled long and hard until 
they were finally persuaded to abandon their enterprise by their

* Interestingly, this condition holds not only for the facts that constitute the 
initial and final conditions but also for the generalizations that connect them. 
The laws of nature must prevail whether they are recognized or not. This is the 
basis of Popper's abortive idea of a "third world" of objective thoughts (in 
Objective Knowledge, New York: Oxford University Press, 1972).

The Theory of Reflexivity 3 7 
lack of success. The lailure was inevitable because the behavior 
of base metals is governed by laws of universal validity which 
cannot be modified by any statements, incantations, or rituals. 
Let us now consider the behavior of human beings. Do they 
obey universally valid laws that can be formulated in accordance 
with the D-N model? Undoubtedly, there are many aspects of 
human behavior, from birth to death and in between, which are

amenable to the same treatment as other natural phenomena. But 
there is one aspect of human behavior which seems to exhibit 
characteristics different from those of the phenomena which form 
the subject matter of natural science: the decision-making pro- 
cess. Decisions are based on an imperfect understanding of the 
situation. How does such a situation provide the initial and final 
conditions which are supposed to be connected according to laws

of universal validity? Do those conditions include or exclude the 
participants' thinking? If thinking is included, the conditions are 
not amenable to scientific observation, because only the effects of 
the participants' thinking can be observed, not the process itself. 
If the thinking process is excluded and only its effects are admit- 
ted as evidence, the universal validity of scientific generalizations 
is destroyed because a given set of conditions is not necessarily

preceded or succeeded by the same set every time: the sequence 
of events is influenced by the participants' thinking, yet there is a 
lack of correspondence between the participants' thinking and 
the course of events. In either case, the D-N modabreaks down. 
This may not be the end of the world, but it is a serious blow to 
scientific method. The method has been so successful that we find 
it hard to believe that there should be a large and vital area be-

yond its scope. Natural science has aiso encountered limitations 
in the form of Heisenberg's uncertainty principle but the limits 
were reached only after a number of impressive accomplishments 
-the uncertainty principle itself counts as one of the great dis- 
coveries of natural science. In social science we encounter diffi- 
culties even before we get started: the imperfect understanding of 
the participants is incompatible with the D-N model.

This conclusion is so devastating that every effort has been 
made to escape it. To review the various attempts would take a 
whole book-and an interesting one at that. I shall confine my 
attention to economic theory, which constitutes one of the most 
ingenious attempts, and in some ways the most effective one, to 
escape the problems connected with imperfect understanding. It

3 8 Theory 
simply assumes away the problems by erecting a hypothetical 
system in which the participants' decisions are fully determined 
by the available information. This approach yields conclusions 
which meet some of the requirements of the D-N model. For in- 
stance, the theory of perfect competition qualifies as universally 
valid and-at least in principle-it can be used to explain and 
predict conditions with equal force. The theory fails, however,

when it comes to testing, leaving in doubt the relevance of the 
hypothetical to actual conditions. 
Social scientists have gone to great lengths trying to maintain 
the unity of method but with remarkably little success. Their 
endeavors have yielded little more than a parody of natural sci- 
ence. In a sense, the attempt to impose the methods of natural 
science on social phenomena is comparable to the efforts of alche- 
mists who sought to apply the methods of magic to the field of

natural science. But while the failure of the alchemists was well- 
nigh total, social scientists have maqaged to make a considerable 
impact on their subject matter. situations which have thinking 
participants may be impervious to the methods of natural'science, 
but they are susceptible to the methods of alchemy. The thinking 
of participants, exactly because it is not governed by reality, is 
easily influenced by theories. In the field of natural phenomena,

scientific method is effective only when its theories are valid; but 
in social, political, and economic matters, theories can be effec- 
tive without being valid. Whereas alchemy has failed as natural 
science, social science can succeed as alchemy. 
This brings us to an examination of the relationship between 
the scientist and his subject matter. As we have seen, the ID-N 
model requires that scie2iists keep their statements and observa-

tions rigorously segregated from the subject matter to which they 
relate; only then can the subject matter fulfill its function and 
serve as an objective criterion for judging the truth or validity of 
scientific statements. The conventions of scientific method are 
designed to maintain the required segregation. 
In natural science the conventions are effective because the 
scientist's thinking is, in fact, distinct from its subject matter. The

scientist can influence the subject matter only by actions, not by 
thoughts, and the scientist's actions are guided by the same laws 
as all other natural phenomena. Specifically, nothing the scientist 
can do will turn base metals into gold. The scientist may gain 
some personal advantage by flouting the conventions of science,

The Theory of Reflexivity 39 
but the advantage is achieved only by a deception which is liable 
to be revealed by those who abide by the conventions. 
Social phenomena are different. The imperfect understanding 
of the participant interferes with the proper functioning of the 
D-N model. This has far-reaching implications for the conven- 
tions of scientific method. It limits the results that can be pro- 
duced by observing thk conventions and, what is worse, it opens

the way to attaining worthwhile results by transgressing them. 
There is much to be gained by pretending to abide by the conven- 
tions of scientific method without actually doing so. Natural sci- 
ence is held in great esteem: a theory that claims to be scientific 
can influence the gullible public much better than one whicn 
frankly admits its political or ideological bias. I only need to 
mention Marxism and psychoanalysis as typical examples; but

laissez-faire capitalism, with its reliance on the theory of perfect 
competition, is also a: case in point. It is noteworthy that both 
Marx and Freud were vocal in protesting their scientific status 
and based many of their conclusions on the authority they de- 
rived from being "scientific." Once this point sinks in, the very 
expression "social science" becomes suspect. It is a magic word 
employed by social alchemists in their effort to impose their will

on their subject matter by incantation. 
How can the "true" practitioners of scientific method protect 
themselves against such malpractice? It seems to me that there is 
only one way out: to deprive social science of theeatus it enjoys 
on account of natural science. Social science ought to be recog- 
nized as a false metaphor. 
That does not mean that we must give up the pursuit of truth 
in exploring social phenomena. It means only that the pursuit of

truth requires us to recognize that the D-N model does not apply 
to situations with thinking participants. We must abandon the 
doctrine of the unity of method and cease the slavish imitation of 
natural science. 
The D-N model has been so successful in natural science that it 
has come to be equated with scientific method. Ironically, the 
model has been largely superseded in modern natural science; the 
social sciences, however, are still trying to compete with the ac-

complishments of nineteenth-century natural science. The at- 
tempt is in vain because, as we have seen, the subject matter does 
not fit the D-N mold. But, as quantum physics has shown, scien- 
tific method is not necessarily confined to the D-N model: statis-

40 Theory 
tical, probabilistic generalizations may prove more fruitful. Nor 
should we ignore the possibility of developing novel approaches 
which have no counterpart in natural science. Given the differ- 
ences in subject matter, there ought to be differences in the 
method of study. 
I shall explore a novel approach in this book, but before I start, 
I want to make sure that it will not be judged by the standards of 
the D-N model. A world of imperfect understanding does not lend

itself to generalizations which can be used to explain and to pre- 
dict specific events. The symmetry between explanation and pre- 
diction prevails only in the absence of thinking participants. 
Otherwise, predictions must always be conditioned on the partic- 
ipants' perceptions; thus they cannot have the finality which they 
enjoy in the D-N model. On the other hand, past events are just as 
final as in the D-N model; thus, ex*nation turns out to be an

easier task than prediction. Once we abandon the constraint that 
predictions and explanations are logically reversible, we can 
build a theoretical framework which is appropriate to the subject 
matter. Unfortunately, the theory cannot be tested in the same 
way ;as those which fit into Popper's logical structure. That is not 
to say that testing must be abandoned; on the contrary, as long as 
we remain concerned with understanding things as they are, we

ought to insist on testing our views. We need to develop novel 
ways of testing. I shall do so in the real-time experiment that 
frankly admits, and exploits, the alchemical potential in the study 
of social phenomena (Part 111). 
The Participants' Bias 
My approach is to tackle the problem of imperfect understanding 
head on. What makes the participants' understanding imperfect 
is that their thinking affects the situation to which it relates. The

causal role played by the participants' thinking has no counter- 
part in the phenomena studied by natural scientists. It is ob- 
viously not the only force shaping the course of events, but it is a 
force which is unique to events that have thinking participants. 
Hence it deserves to take center stage. 
As we have seen, imperfect understanding is a very difficult 
concept to work with. We have established that there is a lack of

correspondence between the participant's thinking and the situa-

The Theory of Reflexivity 41 
tion to which it relates; but the lack of correspondence is difficult 
to define, let alone measure. The participant's thinking is part of 
the situation to which it relates and the very idea of correspon- 
dence is inappropriate to describing a relationship between a part 
and a whole. The idea :was imported from natural science, where 
facts and statements belong to separate universes and from phi- 
losophy, where correspondence serves as the criterion of truth.

The analogy does not apply to the participant who is, by defini- 
tion, part of the situation that he is trying to understand. We can 
speak of a lack of correspondence, but we cannot define that to 
which the participant's understanding fails to correspond be- 
cause it sillrply does dot exist. To simplify rn~tttzrs, I sha!! speak 
of an inherent bias in the participants' thinking. Since the bias is 
inherent, the unbiased is unattainable.

inherent, the unbiased is unattainable. 
There is, however, a norm in the outside world against which 
the participants' bias can be measured. Although there is no real- 
ity independent of the participants* perception, there is a reality 
that is dependent on ;it. In other words, there is a sequence of 
events that actually occurs and that sequence reflects the partici- 
pants' behavior. The actual course of events is likely to differ from

the participants' expectations and the divergence can be taken as 
an indication of the participants' bias. Unfortunately, it can be 
taken only as an indication-not as the full measure of the bias- 
because the actual course of events already incorporates the ef- 
fects of the participants' thinking. Thus the participants' bias 
finds expression both in the divergence between outcome and 
expectations and in the actual course of events. A phenomenon

that is partially observable and partially submerged in the course 
of events does not lend itself readily to scientific investigatiorr. 
We can now appreciate why economists were so anxious to elim- 
inate it from their theories. We shall make it the focal point of our 
investigation. 
The Concept of Reflexivity 
The connection between the participants' thinking and the situa- 
tion in which they participate can be broken up into two func-

tional relationships. I call the participants' efforts to understand 
the situation the cognitive or passive function and the impact of 
their thinking on the real world the participating or active func-

42 Theory 
tion. In the cognitive function, the participants' perceptions de- 
I pend on the situation; in the participating function, the situation 
is influenced by the participants' perceptions. It can be seen that 
the two functions work in opposite directions: in the cognitive 
function the independent variable is the situation; in the partici- 
pating function it is the participants' thinking. 
There are many cases where one or the other function can be

observed in isolation but there are also instances where they are 
both operating at the same time. An obvious example of the cog- 
nitive function is when someone learns from experience. Exam- 
ples of the participating function are to be found in textbooks of 
economics where the participants apply a given set of preferences 
to a given set of opportunities and in the process determine 
4 prices. When both functions operate at the same time, they interfere

with each other. Functions need an independent variable in order 
to produce a determinate result, but in this case the independent 
variable of one function is the dependent variable of the other. 
Instead of a determinate result, we have an interplay in which 
both the situation and the participants' views are dependent vari- 
ables so that an initial change precipitates further changes both in 
the situation and in the participants' views. I call this interaction

"reflexivity," using the word as the French do when they describe 
a verb whose subject and object are the same. Using simple math- 
ematics, reflexivity can be depicted as a pair of recursive func- 
tions: 
y = f (x) cognitive function 
x = + (yj partlcipati~~g function 
Therefore, 
This is the theoretical foundation of my approach. The two 
recursive functions do not produce an equilibrium but a never- 
ending process of change. The process is fundamentally different

from the processes that are studied by natural science. There, one 
set of facts follows another without any interference from 
thoughts or perceptions (although in quantum physics, observa-

The Theory of Reflexivity 43 
tion introduces uncertqinty). When a situation has thinking par- 
ticipants, the sequence of events does not lead directly from one 
set of facts to the next; rather, it connects facts to perceptions and 
perceptions to facts in a shoelace pattern. Thus, the concept of 
reflexivity yields a "shoelace" theory of history. 
It must be recognized that the shoelace theory is a kind of di- 
alectic. It can be intergreted as a synthesis of Hegel's dialectic of

ideas and Marx's dialectical materialism. Instead of either 
thoughts or material conditions evolving in a dialectic fashion on 
their own, it is the interplay between the two that produces a 
dialectic process. The' only reason I do not use the word more 
prominently is that I do not want .icu be burdened by the excess , 
luggage that comes with it. I find Hegel obscure, and Marx pro- 
pounded a deterministic theory of history that is diametrically 
opposed to my own view.

opposed to my own view. 
The historical process, as I see it, is open ended. Its main driv- 
ing force is the participants' bias. To be sure, it is not the only 
force at work, but it js a force that is unique to the historical 
process and sets it apart from the processes studied by natural 
science. Biological evblution is attributed to genetic mutation; I 
contend that historical processes are shaped by the misconcep- 
tions of the participants. I would even go as far as to say that the

ideas that make histor) consist of fertile fallacies. A fertile fallacy 
is originally conceived as an insight; only when it is translated 
into reality do its shortcomings become apparenMt then begets 
another fertile fallacy that is antithetical to it, and so it goes. Each 
fallacy provides a new experience and, to the extent that people 
learn from experience, the process can be described as progress. 
Fallacy is, of course, too strong a word, but it is helpful in direct-

ing attention in the right direction: to the participants' bias. 
I shall not pursue the subject further here, but it is obvious that 
the concept of reflexivity, as described here, has implications far 
beyond the range of topics tackled in this book. 
Reflexivity Versus Equilibrium 
Returning to economic theory, it can be argued that it is the par- 
ticipants' bias that renders the equilibrium position unattainable. 
The target toward which the adjustment process leads incorpo-

44 Theory 
happens, the process aims not at an equilibrium but at a moving 
target. 
To put matters into perspective, we may classify events into 
two categories: humdrum, everyday events that are correctly an- 
ticipated by the participants and do not provoke a change in their 
perceptions, and unique, historical events that affect the partici- 
pants' bias and lead to further changes. The first kind of event is 
susceptible to equilibrium analysis, the second is not: it can be

understood only as part of a historical process. 
In everyday events, only the participating function is operative; 
the cognitive function is given. In the case of unique, historic 
developments, both functions operate simuitaneously so that nei- 
ther the participants' views nor the situation to which they relate 
remain the same as they were before. That is what justifies de- 
scribing such developments as historic. 
It should be emphasized that my definition of historical change

involves a tautology. First, I classify events according to their ' 
effect on the participants' bias: those that alter the participant's 
bias are historic and those that do not are humdrum. I then claim 
that it is changes in the participants' bias that qualify a course of 
events as historical. 
Tautologies can be useful, provided they are recognized as 
such. In this case it helps to put equilibrium analysis into the 
proper perspective. I have defined historical change as an inter-

play between the cognitive and participating functions. What 
makes the change historical is that it affects both the course of 
events and the participants' perceptions so that the next event 
cannot be a mere repetition of the one that preceded 'it. 
Equilibrium analysis eliminates historical change by assum- 
ming away the cognitive function. The supply and demand curves 
utilized by economic theory are expressions of the participating

function only. The cognitive function is replaced by the assump- 
tion of perfect knowledge. If the cognitive function were operat- 
ing, events in the marketplace could alter the shape of the demand 
and supply curves, and the equilibrium studied by economists 
need never be reached. 
How significant is the omission of the cognitive function? In 
other words, how significant is the distortion introduced by ne- 
glecting the participants' bias?

glecting the participants' bias? 
In microeconomic analysis, the distortion is negligible and the 
participants' bias can be accounted for easily. As a first step, the

The Theory of Reflexivity 45 
participants' bias can be taken as given: that provides a static 
equilibrium. To make the analysis more dynamic, changes in the 
participants' bias can be added piecemeal, expressed as changes 
in consumer habits or production methods. All that is obscured 
by this piecemeal approach is the possible connection between 
the various changes in the conditions of supply and demand, but 
that omission does nbt invalidate the conclusions microeconomic

analysis seeks to establish. 
When it comes to financial markets, the distortion is more seri- 
ous. The participants' bias is an element in determining prices 
and no important niarket development leaves the participants' 
bias unaffected. The'search for an equilibrium price turns out to 
be a wild goose chase and theories about the equilibrium price 
can themselves become a fertile source of bias. To paraphrase J. 
P. Morgan, financial markets will continue to fluctuate.

In trying to deal with macroeconomic developments, equilib- 
rium analysis is totally inappropriate. Nothing could be further 
removed from reality than the assumption that participants base 
their decisions on perfect knowledge. People are groping to antic- 
ipate the future with the help of whatever guideposts they can 
establish. The outcome tends to diverge from expectations, lead- 
ing to constantly chgnging expectations and constantly changing 
outcomes. The process is reflexive.

outcomes. The process is reflexive. 
In his General Theory of Employment, Interest and Money, 
Keynes managed to show that full employmentT% a special case; 
if we could develop a general theory of reflexivity, equilibrium 
would appear as a special case. While it will hardly qualify as a 
general theory, I shall try to explore the role of reflexivity in 
financial markets; that means that I shall try to inierpret their 
functioning as a historical process.

REFLEXIVITY LN THE STOCK MARKET 
In trying to develop a theory of reflexivity, I shall start with the 
stock market. For one thing, it is the market I am most familiar 
with: I have been a professional investor for more than twenty- . 
five years. For another, the stock market provides an excellent 
laboratory for testing theories: changes are expressed in quantita- 
tive terms and the data are easily accessible. Even the partici-

pants' views are usually available in the form of brokers' reports. 
Most important, I have actually tested my theory in the stock 
market and 1 have some interesting case studies to present. 
As I mentioned in the introduction, I did not develop my ideas 
on reflexivity in connection with my activities in the stock mar- 
ket. The theory of reflexivity started out as abstract philosophical 
speculation and only gradually did I discover its ~lev~nce to t?ae

behavior of stock prices. I was singularly unsuccessful in formu- 
lating my theory at the level of abstraction at which I conceived 
it: my failure as a philosopher stands in stark contrast with my 
career as an investment professional. I hope that by presenting 
my ideas in the reverse order from the one in which I arrived at 
them I may be able to avoid getting lost in arcane abstractions. 
There is yet another reason why the stock market may provide

the best entry point for the study of reflexive phenomena. The 
stock market comes as close to meeting the criteria of perfect 
competition as any market: a central marketplace, homogeneous 
products, low transaction and transportation costs, instant com- 
munications, a large enough crowd of participants to ensure that 
no individual can influence market prices in the ordinary course 
of events, and special rules for insider transactions as well as

Reflexivity in the Stock Market 4 7 
special safeguards to provide all participants with access to rele- 
vant information. What more can one ask for? If there is any place 
where the theory of perfect competition ought to beatranslated 
into practice, it is in the stock market. 
Yet there is little edpirical evidence of an equilibrium or even 
a tendency for prices tp move toward an equilibrium. The concept 
of an equilibrium seems irrelevant at best and misleading at

worst. The evidence shows persistent fluctuations, whatever 
length of time is chosen as the period of observation. Admittedly, 
the underlying conditions that are supposed to be reflected in 
stock prices are also ,constantly changing, but it is difficult to 
establish any firm relationship between changes in stock prices 
and changes in underlying conditions. Whatever relationship can 
be established has to be imputed rather than observed. I intend to

use the theory of reflexivity to criticize the preoccupation of eco- 
nomic theory with the equilibrium position. What better example 
could I find than the stock market? 
Existing theories about the behavior of stock prices are remark- 
ably inadequate. They are of so little value to the practitioner that 
I am not even fully familiar with them. The fact that I could get 
by without them speaks for itself. 
Generally, theories fall into two categories: fundamentalist and

technical. More recently, the random walk theory has come into 
vogue; this theory holds that the market fully discsunts all future 
developments so that the individual participant's chances of 
over- or underperforming the market as a whole are even. This 
line of argument has served as theoretical justification for the 
increasing number of institutions that inyest their money in index 
funds. The theory is manifestly false-I have disproved it by con-

sistently outperforming the averages over a period of twelve 
years. Institutions may be well advised to invest in index funds 
rather than making specific investment decisions, but the reason 
is to be found in their substandard performance, not in the impos- 
sibility of outperforming the averages. 
Technical analysis studies market patterns and the demand and 
supply of stocks. It has undoubted merit in predicting probabili-

ties but not the actual course of events. For the purposes of this 
discussion it is of no particular interest, because it has little the- 
oretical foundation other than the assertions that stock prices are 
determined by their supply and demand and that past experience 
is relevant in predicting the future. 
Fundamental analysis is more interesting because it is an out-

48 Theory 
growth of equilibrium theory. Stocks are supposed to have a true 
I or fundamental value as distinct from their current market price. 
The fundamental value of a stock may be defined either in rela- 
tion to the earning power of the underlying assets or in relation 
to the fundamental value of other stocks. In either case, the mar- 
ket price of a stock is supposed to tend toward its fundamental 
value over a period of time so that the analysis of fundamental

values provides a useful guide to investment decisions. 
The important point about this approach is that the connection 
between stock prices and the companies whose stocks are traded 
is assumed to be in one direction. The fortunes of the companies 
determins--however belatedly-the relative values of the var- 
ious stocks traded in the stock market. The possibility that stock 
market developments may affect the fortunes of the companies is

left out of account. There is a clear parallel with the theory of 
price where the indifference curve determines the relative 
amounts consumed, and the possibility that the market may influ- 
ence the indifference curve is disregarded. The parallel is not 
accidental: the fundamentalist approach is based on the theory of 
price. But the omission is more glaring in the stock market than 
in other markets. Stock market valuations have a direct way of

influencing underlying values: through the issue and repurchase 
of shares and options and through corporate transactions of all 
kinds-mergers, acquisitions, going public, going private, and so 
on. There are also more subtle ways in which stock prices may 
influence the standing of a company: credit rating, consumer ac- 
ceptance, management credibility, etc. The influence of these fac- 
tors on stock prices is, of course, fully recognized; it is the

influence of stock pric2s on these factors that is so strangely ig- 
nored by the fundamentalist approach. 
If there are any glaring discrepancies between prevailing stock 
prices and fundamental values, they are attributed to future de- 
velopments in the companies concerned that are not yet known 
but are correctly anticipated by the stock market. Movements in 
stock prices are believed to precede the developments that sub- 
sequently justify them. How future developments ought to be dis-

counted is the subject of an ongoing debate, but it is presumed 
that the market is doing the job correctly even if the correct 
method cannot be theoretically established. This point of view 
follows naturally from the theory of perfect competition. It is 
summed up in the assertion that "the market is always right." The

Reflexivity in the Stock Market 49 
assertion is generally accepted, even by people who do not put 
much faith in fundamental analysis. 
I take a totally opposite point of view. I do not accept the prop- 
osition that stock prices are a passive reflection of underlying 
values, nor do I accept Rhe proposition that the reflection tends to 
correspond to the underlying value. I contend that market valua- 
tions are always distohed; moreover-and this is the crucial de-

parture from equilibrium theory-the distortions can affect the 
underlying values. Stock prices are not merely passive reflections; 
they are active ingredients in a process in which both stock prices 
and the fortunes of the companies whose stocks are traded are 
determined. In other words, I regard changes in stock prices as 
part of a historical process and I focus on the discrepancy be- 
tween the participants' expectations and the actual course of

events as a causal factor in that process. 
To explain the process, I take the discrepancy as my starting 
point. I do not rule out the possibility that events may actually 
correspond to people's expectations, but I treat it as a limiting 
case. Translating this assertion into market terms, I claim that 
market participants are always biased in one way or another. I do 
not deny that markets have a predictive or anticipating power that

seems uncanny at times, but I argue that it can be explained by 
the influence that the participants' bias has on the course of 
events. For instance, the stock market is generally believed to 
anticipate recessions; it would be more correct to""say that it can 
help to precipitate them. Thus I replace the assertion that markets 
are always right with two others: 
1. Markets are always biased in one direction or another. 
2. Markets can influence the events that they anticipate.

The combination of these two assertions explains why markets 
may so often appear to anticipate events correctly. 
Using the participants' bias as our starting point, we can try to 
build a model of the interaction between the participants' views 
and the situation in which they participate. What makes the anal- 
ysis so difficult is that the participants' views are part of the 
situation to which they relate. To make any sense of such a com-

plex situation, we need to simplify it. I introduced a simplifying 
concept when I spoke of the participants' bias. Now I want to take

50 Theory 
the argument a step further and introduce the concept of a pre- 
vailing bias. 
Markets have many participants, whose views are bound to 
differ. I shall assume that many of the individual biases cancel 
each other out, leaving what I call the "prevailing bias." This 
assumption is not appropriate to all historical processes but it 
does apply to the stock market and to other markets as well. What 
makes the procedure of aggregating individual perceptions legit-

imate is that they can be related to a common denominator, 
namely, stock prices. In other historical processes, the partici- 
pants' views are too diffuse to be aggregated and the concept of a 
prevailing bias becomes !ittie more than a metaphor. In these 
cases a different model may be needed, but in the stock market 
the participants' bias finds expression in purchases and sales. 
Other things being equal, a positive bias leads to rising stock

prices and a negative one to falling prices. Thus the prevailing 
bias is an observable phenomenon. 
Other things are, of course, never equal. We need to know a 
little more about those "other things" in order to build our model. 
At this point I shall introduce a second simplifying concept. I 
shall postulate an "underlying trend" that influences the move- 
ment of stock prices whether it is recognized by investors or not. 
The influence on stock prices will, of course, vary, depending on

the market participants' views. The trend in stock prices can then 
be envisioned as a composite of the "underlying trend" and the 
"prevailing bias." 
How do these two factors interact? It will be recalled that there 
are two connections at play: the participating and the cognitive 
functions. The underlying trend influences the participants' per- 
ceptions through the cognitive function; the resulting change in 
perceptions affects the situation through the participating func-

tion. In the case of the stock market, the primary impact is on 
stock prices. The change in stock prices may, in tun, affect both 
the participants' bias and the underlying trend. 
We have here a reflexive relationship in which stock prices are 
determined by two factors-underlying trend and prevailing bias 
-both of which are, in turn, influenced by stock prices. The in- 
terplay between stock prices and the other two factors has no

constant: what is supposed to be the independent variable in one 
function is the dependent variable in the other. Without a con- 
stant, there is no tendency toward equilibrium. The sequence of

Reflexivity in the Stock Market 51 
events is best interpreted as a process of historical change in 
which none of the variables-stock prices, underlying trend, and 
prevailing bias-remains as it was before. In the typical sequence 
the three variables reinforce each other first in one direction and 
then in the other in a battern that is known, in its simplest form, 
as boom and bust. ' 
First, we must startowith some definitions. When stock prices

reinforce the underlyihg trend, we shall call the trend self-rein- 
forcing; when they work in the opposite direction, self-correcting. 
The same terminology holds for the prevailing bias: it can be self- 
reinforcing or self-correcting. It is important to realize what these 
terms mean. When a trend is reinforced, it accelerates. Yhsn the 
bias is reinforced, the divergence between expectations and the 
actual course of future stock prices gets wider and, conversely,

when it is self-correcting, the divergence gets narrower. As far as 
stock prices are concerned, we shall describe them simply as ris- 
ing and falling. When the prevailing bias helps to raise prices we 
shall call it positive; ,when it works in the opposite direction, 
negative. Thus rising prices are reinforced by a positive bias and 
falling prices by a negative one. In a boomhust sequence we 
would expect to find at least one stretch where rising prices are

reinforced by a positive bias and another where falling prices are 
reinforced by a negative bias. There must also be a point where 
the underlying trend and the prevailing bias combine to reverse 
the trend in stock prices. “ee 
Let us now try to build a rudimentary model of boom and bust. 
We start with an underlying trend that is not yet recognized- 
although a prevailing bias that is not yet reflected in stock prices 
is also conceivable. Thus, the prevziling bias is negstive to start

with. When the market participants recognize -Che trend, this 
change in perceptions will affect stock prices. The change in stock 
prices may or may not affect the underlying trend. In the latter 
case, there is little more to discuss. In the former case we have the 
beginning of a self-reinforcing process. 
The enhanced trend will affect the prevailing bias in one of two 
ways: it will lead to the expectation of further acceleration or to

the expectation of a correction. In the latter case, the underlying 
trend may or may not survive the correction in stock prices. In 
the former case, a positive bias develops causing a further rise in 
stock prices and a further acceleration in the underlying trend. As 
long as the bias is self-reinforcing, expectations rise even faster

5 2 Theory 
than stock prices. The underlying trend becomes increasingly in- 
t fluenced by stock prices and the rise in stock prices becomes 
increasingly dependent on the prevailing bias, so that both the 
underlying trend and the prevailing bias become increasingly vul- 
nerable. Eventually, the trend in prices cannot sustain prevailing 
expectations and a correction sets in. Disappointed expectations 
have a negative effect on stock prices, and faltering stock prices

weaken the underlying trend. If the underlying trend has become 
overly dependent on stock prices, the correction may turn into a 
total reversal. In that case, stock prices fall, the underlying trend 
is reversed, and expectations fall even further. In this way, a self- 
reinforcing process gets started in the opposite dircctior,. EVGE 
tually, the downturn also reaches a climax and reverses itself. 
Typically, a self-reinforcing process-undergoes orderly correc-

I tions in the early stages, and, if it survives them, the bias tends to 
be reinforced, and is less easily shaken. When the process is ad- 
vanced, corrections become scarcer and the danger of a climactic 
reversal greater. 
I have sketched out a typical boomhust sequence. It can be 
illustrated by two curves that follow more or less the same direc- 
tion. One represents stock prices, and the other, earnings per 
share. It would be natural to envision the earnings curve as a

measure of the underlying trend, and the divergence between the 
two curves as an indication of the underlying bias. The relation- 
ship is much more complex. The earnings curve incorporates not 
only the underlying trend but also the influence of stock prices 
on that trend; the prevailing bias is expressed only partially by 
the divergence between the two curves-partially it is already 
reflected in those curves. Concepts that are only partially observ-

able are extremely difficult to work with; that is why we have 
chosen variables that can be observed and quantified-although, 
as we shall see later, the quantification of earnings per share can 
be very misleading. For present purposes, we shall assume that 
the "fundamentals" in which investors are interested are properly 
measured by earnings per share. 
A typical path for the two curves may be as follows. (See the 
figure below.) At first, recognition of an underlying trend is lag-

ging but the trend is strong enough to manifest itself in earnings 
per share (AB). When the underlying trend is finally recognized, 
it is reinforced by rising expectations (BC). Doubts arise, but the 
trend survives. Alternatively, the trend waivers but reasserts it-

Reflexivity in the Stock Market 5 3 
I I 
AB C D E F G H I 
Time d 
self. Such testing may be repeated several times, but here I show 
it only once (CD). ~ventuall~, conviction develops and it is no 
longer shaken by a setback in the earning trend (DE). Expectations 
become excessive, and fail to be sustained by reality (EF). The 
bias is recognized as such and expectations are lowered (FG). 
Stock prices lose their, last prop and plunge (G). The underlying

trend is reversed, reinforcing the decline (GH). Eventually, the 
pessimism becomes overdone and the market stabilizes (HI). 
It should be emphasized that this is only one po&ble path that 
results from the interplay of a single underlying trend and a pre- 
vailing bias. There could be more than one trend at work and the 
prevailing bias could have many nuances, so that the sequence of 
events might require a totally different representation.

A few words about the theoretical construction of the model 
may be in order. We are interested in the interplay between the 
participants' bias and the actual course of events. Yet the partici- 
pants' bias is not directly represented in our model; both curves 
denote the actual course of events. The prevailing bias is partially 
incorporated in the two curves and partially denoted by the di- 
vergence between them. 
The great merit of this construction is that it uses variables that

can be quantified. Stock prices serve as a convenient proxy for the 
situation to which the participants' bias relates. In other historical 
processes the situation that is interconnected with the partici-

54 Theory 
pants' perception by the cognitive and participating functions is 
t more difficult to identify and impossible to quantify. It is the 
availability of a convenient proxy that renders the stock market 
such a useful laboratory for studying reflexivity. 
Unfortunately, the model offers only a partial explanation of 
how stock prices are determined. The concept of an underlying 
trend has been introduced as a placeholder term, to denote

changes in the "fundamentals." What the fundamentals are has 
not been defined. Even the question of how the fundamentals are 
to be measured has not been answered. Earnings, dividends, asset 
value, free cash flow: all these yardsticks are relevant, as well as 
many others, but the relative weight given to each depends on the 
investors' jadgments and is therefore subject to their bias. We may 
use earnings per share for purposes of illustration, but that merely

4 begs the question. It is a question security analysts have been 
struggling with for a long time. We do not need to answer it here 
in order to develop a theory of reflexivity. 
Without knowing afiything about the fundamentals we can 
make some worthwhile generalizations. The first generalization is 
that stock prices must have some effect on the fundamentals 
(whatever they are), in order to create a boomhust pattern. Some- 
times the connection is direct, as in the examples I shall use in

this chapter, but generally it is indirect. Often it makes its effect 
felt through a political process, such as changes in taxation, or 
regulation, or attitudes to saving and investment. 
It is possible to have a reflexive connection between stock 
prices and the prevailing bias even if the fundamentals remain 
unaffected, but the connection becomes interesting only if the 
fundamentals are also involved. Without a change in fundamen-

tals, the prevailing bias is likely to be corrected in short order, as 
we can observe in the daily fluctuations of stock prices. It would 
be quite in order to ignore the bias as mere noise. That is what the 
theory of perfect competition and the fundamentalist approach to 
security analysis have done. By contrast, when the fundamentals 
are affected, the bias cannot be left out of account without se- 
rious distortion, because the bias gives rise to a self-reinforcing/

self-defeating process that leaves neither stock prices, nor the 
fundamentals, nor the participants' views the same as they were 
before. 
The second generalization is that there is bound to be a flaw in 
the participants' perception of the fundamentals. The flaw may

Reflexivity in the Stock Market 55 
not be apparent in the early stages but it is likely to manifest itself 
later on. When it does, it sets the stage for a reversal in the pre- 
vailing bias. If the change in bias reverses the underlying trend a 
self-reinforcing process is set in motion in the opposite direction. 
What the flaw is and how and when it is likely to manifest itself 
are the keys to understanding boomhust sequences. 
The model I presented above is built on these two generaliza-

tions. It hardly needs emphasizing how crude the mode1 is. 
Nevertheless, it is valuable in identifying the crucial features of a 
typical boombust sequence. These are the unrecognized trend; 
the beginning of a self-reinforcing process; the successful test; the 
growing conviction, resulting in a widening divergence between 
reality and expectations; the flaw in perceptions; the climax; a 
self-reinforcing process in the opposite direction. Just by identi-

fying these features we can gain some insight into the behavior of 
stock prices. We cannot expect much more from our rudimentary 
model. 
In any case, a reflexive model cannot take the place of funda- 
mental analysis: all it can do is to provide an ingredient that is 
missing from it. In principle, the two approaches could be recon- 
ciled. Fundamental analysis seeks to establish how underlying 
values are reflected in stock prices, whereas the theory of re-

flexivity shows how stock prices can influence underlying 
values. One provides a static picture, the other a dynamic 
one. 
A theory that offers a partial explanation of st@% price move- 
ments can be very useful to the investor especially if it illumi- 
nates a relationship that other investors fail to grasp. Investors 
operate with limited funds and limited intelligence: they do not 
need to know everything. As long as they understand something

better than others, they have an edge. The trouble with any kind 
of specialized knowledge is that one's area of expertise may not 
be especially interesting, but the theory of reflexivity serves to 
identify historically significant price movements, so it goes right 
to the heart of the matter. 
The rudimentary model I have outlined above has proved 
extremely rewarding in my career as an investor. That may 
seem surprising because the model is so simple and it fits a well-

trodden stock market pattern so well that one would expect every 
investor to be familiar with it. Yet, that is not the case. Why? Part 
of the answer must be that market participants have been mis-

56 Theory 
guided by a different theoretical construction, one derived from 
4 classical economics and, even more important, from the natural 
sciences. The ingrained attitude is that stock prices are the pas- 
sive reflection of some underlying reality and not an active ingre- 
dient in the historical process. This view is simply false. It is 
remarkable that the error has still not been fully recognized. 
Nevertheless, investors do recognize the sequence I have de-

scribed and do respond to it, only they respond later than some- 
one who is working with the appropriate model and is on the 
lookout for the crucial features that define the shape of the price 
curve. That is what has given me my edge. 
The first time I used the model systematically was in the cm- 
glomerate boom oi the late 1960s. It enabled me to make money 
both on the way up and on the way down. 
I The key to the conglomerate boom was a pre~ailing misconcep-

tion among investors. Investors had come to value growth in 
per-share earnings and failed to discriminate about the way the 
earnings growth was accomplished. A few companies learned to 
produce earnings growth through acquisitions. Once the market 
started to reward them for their performance, their task became 
easier because they could offer their own highly priced stock in 
acquiring other companies. 
In theory, the process works as follows. Let us assume that all

of the companies involved have the same intrinsic growth in earn- 
ings but the stock of the acquiring company sells at twice the 
earnings multiple of the acquired ones; if the acquiring company 
manages to double its size, its earnings per share jump by 50%, 
and its growth rate increases accordingly. 
In practice, the early conglnmerates started out with high in- 
trinsic growth rates that were rewarded by high multiples. Several 
of the pathbreakers were high-technology companies with a

strong defense component whose managements recognized that 
their historic growth rate could not be sustained indefinitely: Tex- 
tron, Teledyne, Ling-Temco-Vought (later LTV), to mention a few. 
They started to acquire more mundane companies, but, as their 
per-share earnings growth accelerated, the multiples expanded 
instead of contracting. Their success attracted imitators and later 
on even the most humdrum companies could attain a high multi-

ple by going on an acquisition spree. For instance, the bulk of 
Ogden's earnings was derived from trading scrap metal; neverthe- 
less, the stock sold at more than twenty times earnings at its peak.

Reflexivity in the Stock Market 5 7 
Eventually, a company could achieve a high multiple just by 
promising to put it to good use by making acquisitions. 
Managements developed special accounting techniques that en- 
hanced the impact of acquisitions. They also introduced changes 
in the acquired compahies, streamlining operations, disposing of 
assets, and generally; focusing on the bottom line, but these 
changes were less sigriificant than the impact on per-share earn-

ings of the acquisitions themselves. 
Investors responded like Indians to firewater. At first, the rec- 
ord of each company was judged on its own merit, but gradually 
conglomerates became recognized as a group. A new breed of 
investors emerged, thp so-called go-go fund managers, or gun- 
slingers, who developed a special affinity with the managements 
of conglomerates. Direct lines of communication were opened 
between them and conglomerates would place so-called "letter

stock" directly with investors. Eventually, conglomerates learned 
to manage their stock prices as well as their earnings. 
Events followed th4 sequence described in my model. Multi- 
ples expanded and eventually reality could not sustain expecta- 
tions. More and more people realized the misconception on 
which the boom rested even as they continued to play the game. 
Acquisitions had to get larger and larger in order to maintain the

momentum, and in the end they ran into the limits of size. The 
climactic event was the attempt by Saul Steinberg to acquire 
Chemical Bank: it was fought and defeated by the establishment. 
When stock prices started to fall, the decline fedon itself. The 
favorable impact of acquisitions on per-share earnings dimin- 
ished and eventually it became impractical to make new acquisi- 
tions. The internal problems that had been swept under the carpet

during the period of rapid external growth began to surface. Earn- 
ings reports revealed unpleasant surprises. Investors became dis- 
illusioned and managements went through their own crises: after 
the heady days of success, few were willing to buckle down to 
the burdens of day-to-day management. The situation was aggra- 
vated by recession, and many of the high-flying conglomerates 
literally disintegrated. Investors were prepared to believe the

worst and in some cases the worst actually occurred. In others, 
reality turned out to be better than expectations and eventually 
the situation stabilized with the surviving companies, often under 
new management, slowly working themselves out from under the 
debris.

Theory 
The conglomerate boom is particularly well suited to serve as 
4 an illustration of my rudimentary model because the "fundamen- 
tals" are readily quantified. Investors based their valuations on 
reported per-share earnings. However meaningless the figures, 
they provide charts that closely conform to my theoretical proto- 
type. Here they are: 
Courtesy of Securities Research Company, a Division of Babson-United Investment Advisors, Inc., 
208 Newbury St., Boston, MA 02116.

Reflexivity in the Stock Market 59 
Courtesy of Securities Research Company, a Division of Babson-United InvsrLLhent Advisors. Inc.. 

Theory 
Courtesy of Securities Research Company, a Division of Babson-United Investment Advisors. Inc., 
208 Newbury St., Boston, MA 02116. 
My best documented encounter with a boom/bust sequence is 
that of Real Estate Investment Trusts. REITs, as they are called, 
are a special corporate form brought into existence by legislation. 
Their key feature is that they can distribute their income free of 
corporate taxation, provided they distribute all the income they

receive. The opportunity created by this legislation remained 
largely unexploited until 1969 when a large number of REITs 
were founded. I was present at the creation and, fresh from my 
experience with conglomerates, recognized their boom/bust po- 
tential. I published a research report whose key part reads as 
follows:

Reflexivity in the Stock Market 6 1 
THE CAS~ FOR MORTGAGE TRUSTS 
(February 1970) 
THE CONCEPT 
Superficially, mortgage trusts seem to resemble mutual funds 
designed to provide hi~h current yields. But the analogy is mis- 
leading. The true attraction of mortgage trusts lies in their ability 
to generate capital gains for their shareholders by selling additional 
shares at a premium over book value. If a trust with a book value 
of $10 and a 12% return on equity doubles its equity by selling

additional shares at $20, the book value jumps to $13.33 and per- 
share earnings go from $1.20 to $1.60. 
Investors are willing to pay a premium because of the high yield 
and the expectation of per-share earnings growth. The higher the 
premium, the easier it is for the trust to fulfill this expectation. The 
process is a self-reinforcing one. Once it gets under way, the trust 
can show a steady growth in per-share earnings despite the fact

that it distributes practjcally all its earnings as dividends. Investors 
who participate in the process early enough can enjoy the com- 
pound benefits of a high return on equity, a rising book value, and 
a rising premium over book value. 
ANALYTICAL APPROACH 
The conventional method of security analysis is to try and pre- 
dict the future course of earnings and then to estimate the price 
that investors may be willing to pay for those earnings. This

method is inappropriate to the analysis of mortgage trusts because 
the price that investors are willing to pay for the shares is an im- 
portmt factor in determining the future course of earnings. 
Instead of predicting future earnings and valuations separately, 
we shall try to predict the future course of the entire self- 
reinforcing process. We shall identify three major factors which 
reinforce each other and we shall sketch out a scenario of the

probable course of development. The three factors are: 
1. The effective rate of return on the mortgage trust's capital 
2. The rate of growth of the mortgage trust's size 
3. Investor recognition, i.e., the multiple investors are willing 
to pay for a given rate of growth in per-share earnings

62 Theory 
THE SCENARIO 
Act One: At present, the effective yield on construction loans is at 
an optimum. Not only are interest rates high but losses are at a 
relatively low level. There is a pent-up demand for housing and 
new houses readily find buyers. There is a shortage of funds so that 
the projects which do get off the ground are economically well 
justified. Builders who are still in business are more substantial 
and more reliable than at the tail end of a boom. Moreover, they do

their utmost to complete the construction phase as fast as possible 
because money is so expensive. Shortages of labor and material do 
cause defaults and delays but rising costs permit mortgage trusts to 
liquidate their commitments without loss. 
Money is tight and alternative sources of interim financing are 
in short supply. Investor recognition of the mortgage trust concept 
has progressed far enough to permit the formation of new trusts

and the rapid expansion of existing ones. The self-reinforcing pro- 
cess gets under way. 
Act Two: If and when inflation abates, the effective yield on con- 
struction loans will decline. On the other hand, there will be a 
housing boom and bank credit will be available at advantageous 
rates. With higher leverage, the rate of return on equity can be 
maintained despite a lower effective yield. With a growing market 
and growing investor recognition, the premium over book value

may continue to increase. Mortgage trusts are likely to take full 
advantage of the premium and show a rapid rise in both size and 
per-share earnings. Since entry into the field is unrestricted, the 
number of mortgage trusts will also increase. 
Act Three: The self-reinforcing process will continue until mort- 
gage trusts have captured a significant part of %he construction loan 
market. Increasing competition will then force them to take greater

risks. Construction activity itself will have become more specula- 
tive and bad loans will increase. Eventually, the housing boom will 
slacken off and housing surpluses will appear in various parts of 
the country, accompanied by a slack real estate market and tem- 
porary declines in real estate prices. At this point, some of the 
mortgage trusts will be bound to have a large number of delinquent 
loans in their portfolios and the banks will panic and demand that

their lines of credit be paid off. 
Act Four: Investor disappointment will affect the valuation of the 
group, and a lower premium coupled with slower growth will in

Reflexivity in the Stock Market 63 
turn reduce the per-share earnings progression. The multiple will 
decline and the group will go through a shakeout period. After the 
shakeout, the industry will have attained maturity: there will be 
few new entries, regulations may be introduced, and existing trusts 
will settle down to a more moderate growth. 
, I 
EVALUATION I 
The shakeout is a ldng time away. Before it occurs, mortgage 
trusts will have grown manifold in size and mortgage trust shares

will have shown tremendous gains. It is not a danger that should 
deter investors at the p~esent time. 
The only real danger at present is that the self-reinforcing pro- 
cess may not get under way at all. In a really serious stock mamet 
decline investors may be unwilling to pay any premium even for a 
12% return on equity. We doubt that such conditions would arise; 
we are more inclined to expect an environment in which a 12% 
return is more exceptional than it has been recently and in which

the self-reinforcing processes of the last few years, notably con- 
glomerates and computer leasing companies, are going through 
their shakeout period. In such an environment there should be 
enough money available for a self-reinforcing process which is just 
starting, especially if it is the only game in town. 
'"If the process fails to get under way, investors would find down- 
side protection in the book value. The new trusts are coming to the

market at book value plus underwriting commission (usually 10%). 
Most recently formed trusts are selling at a premium which is still 
modest. It will be recalled that when their assets 3fe fully em- 
ployed in interim loans, mortgage trusts can earn 11% on their 
book without leverage and 12% with a 1:l leverage. A modest 
premium over book value would seem justified even in the absence 
of growth. 
If the self-reinforcing process does get under way, shareholders

in well-managed mortgage trusts should enjoy the compound ben- 
efits of a high return on equity, a rising book value, and a rising 
premium over book value for the next few years. The capital gains 
potential is of the same order of magnitude as at the beginning of 
other self-reinforcing processes in recent stock market history. 
My report had an interesting history. It came at a time when go- 
go fund managers had suffered severe losses in the collapse of the

conglomerates. Since they were entitled to share in the profits but 
did not have to share in the losses of the funds they managed,

64 Theory 
they were inclined to grasp at anything that held out the pros- 
I pect of a quick profit. They instinctively understood how a self- 
reinforcing process works since they had just participated in one 
and they were anxious to play. The report found a tremendous 
response whose extent I realized only when I received a telephone 
call from a bank in Cleveland asking for a new copy because theirs 
had gone through so many Xerox incarnations that it was no

longer legible. There were only a few mortgage trusts in existence 
at the time but the shares were so eagerly sought after that they 
nearly doubled in price in the space of a month or so. Demand 
generated supply and there was a flood of new issues coming to 
market. When it became clear that the stream of new mortgage 
trusts was inexhaustible, prices fell almost as rapidly as they had 
gone up. Obviously the readers of the report failed to take into

4 account the ease of entry and their mistake was corrected in short 
order. Nevertheless their enthusiastic reception helped to get the 
self-reinforcing process described in the report under way. Sub- 
sequent events took the course outlined in the report. Mortgage 
trust shares enjoyed a boom that was not as violent as the one that 
followed the publication of the report but turned out to be more 
enduring. 
I had invested heavily in mortgage trusts and took some profits

when the reception of my study exceeded my expectations. But I 
was sufficiently carried away by my own success to be caught in 
the downdraft with a significant inventory. I hung on and even 
increased my positions. I followed the industry closely for a year 
or so and sold my holdings with good profits. Then I lost touch 
with the group until a few years later when problems began to 
surface. I was tempted to establish a short pcsitioo but was hand-

icapped in that I was no longer famiiiar with the terrain. Never- 
theless, when I reread the report I had written several years 
earlier, I was persuaded by my own prediction. I decided to sell 
the group short more or less indiscriminately. Moreover, as the 
shares fell I maintained the same level of exposure by selling 
additional shares short. My original prediction was fulfilled and 
most REITs went broke. The result was that 1 reaped more than

100% profit on my short positions-a seeming impossibility since 
the maximum profit on a short position is 100%. (The explanation 
is that I kept on selling additional shares.) 
Self-reinforcinghelf-defeating cycles like the conglomerate 
boom and the REITs do not occur every day. There are long fallow

Reflexivity in the Stock Market 65 
periods when the specialist in such cycles remains unemployed. 
He need not starve, however. The divergence between underlying 
trends and investor recognition persists at all times and the astute 
investor can take advantage of it. New industries arise, or old ones 
come back into favor. 'Typically, they are inadequately followed 
at first. For instance, when defense spending started to rise in the

early 1970s after a long decline, there were only two or three 
analysts left who follbwed the industry, although it still repre- 
sented a substantial portion of the economy. Those who were left 
were too demoralized to recognize the beginning of a major new 
trend. That was a wqnderful time to invest in defense stocks. 
There were high-tech fiefense stocks that had never been visited 
by an analyst, like E-Systems, Inc., and well-established compa-

nies that had fallen on evil days trying to diversify out of defense, 
like Sanders Associates, or getting caught up in scandals trying to 
sell airplanes through bribery, like Northrop and Lockheed. 
In the case of defense stocks, there was no self-reinforcing pro- 
cess involved but investor recognition certainly helped the price 
of the stocks. Actually, it is a rare case where the investors' bias 
leaves the fundamentals totally unaffected. Even with defense

stocks the prevailing bias played a role, but it was a negative one. 
Lockheed had to be bailed out by the government and companies 
like Sanders Associates had to restructure.their debt by offering 
conver$ble bonds at prices that turned out to be very low in 
retrospect. Only when the negative bias was corrsted was there 
very little further feedback: companies had little need for addi- 
tional capital, and managements, having been burned once before,

were leery of diversifying out of defense. There were exceptions, 
like United Aircraft, but investnrs' bias never turned positive 
enough to allow a self-reinforcing process to get under way: many 
of United Aircraft's acquisitions were for cash and those that in- 
volved stock did not enhance earnings significantly. The result 
was a larger, diversified company, but no boom and bust in the 
stock. 
Perhaps the most interesting case of negative bias occurred in

technology stocks. After the stock market debacle of 1974, inves- 
tors were leery of any company that needed to raise equity capital 
from outside sources. Distributed data processing was in the early 
stages of its development. New companies like Datapoint and 
Four-Phase were in the vanguard with IBM lagging badly. The 
market was practically exploding but these little companies were

66 Theory 
hamstrung by their inability to raise capital. The stocks were sell- 
, ing at very low multiples of anticipated earnings and the main 
argument against them was that they would not be able to grow 
fast enough to meet the demand and eventually IBM would move 
into the market. The argument turned out to be valid, but not 
before these companies became large and prosperous and inves- 
tors became eager to throw money at them at high multiples.

Those who had been willing to fight the negative bias were amply 
rewarded. 
As the various niches occupied by these small companies con- 
verged to form a large market, most of them were absorbed by 
larger companies and thase that stayed independent fel1 on evil 
days. Datapoint is currently looking for a home at a much reduced 
multiple. Four-Phase was recently acquired by Motorola, which 
4 proceeded to lose its shirt on it. If the initial market reaction to

distributed data-processing companies had been more positive, it 
is possible that some of the early starters might have grown fast 
enough to survive, just as the earlier wave of microcomputer man- 
ufacturers did spawn a few enduring companies like Digital 
Equipment and Data General. 
The negative bias of the 1975-1976 period gave way to the 
opposite extreme. It found expression in a venture capital boom 
that culminated in the second quarter of 1983. The sequence of

events is not as clear cut as in the case of REITs, but that is only 
because high technology is not as homogeneous an industry. The 
same reflexive interaction between stock prices, prevailing bias, 
and fundamentals can be observed but much more specific 
knowledge is required to trace the course of events. 
The availability of venture capital on altiticti.~e terms led to a 
proliferation of new ventures. Every new company needed equip-

ment, as well as inventory, so that electronic equipment manufac- 
turers enjoyed a boom, and so did the manufacturers of products 
and components. The electronics industry is a large customer of 
its own products so that the boom was self-reinforcing. But the 
proliferation of companies intensified competition. Industry lead- 
ers lost their market position as a new generation of products was 
introduced because the individuals who were responsible for de-

veloping them left their companies and set up new ones. Instead 
of companies growing in step with their industry, the industry 
grew by the multiplication of companies. Investors failed to rec- 
ognize this trend; as a result, technology stocks in general and 
new issues in particular became substantially overvalued.

Reflexivity in the Stock Market 67 
The new issue boom culminated in the second quarter of 1983. 
When prices started to decline, fewer issues could be sold and 
eventually venture capitalists became less venturesome. As fewer 
companies were formed and the existing ones depleted their cash, 
the market for technqlogy products softened. Competition inten- 
sified and profit margins deteriorated. The process started to feed 
on itself and the low point has probably still not been reached.*

The venture capital boom was not the only cause of the subse- 
quent shakeout-the strong dollar and the rise of Japanese com- 
petition were at least as important-but it is clear that stock 
prices had an impact bn the "fundamentals" in both directions. 
What distinguishes' the conglomeldie and mXT sequznces from 
the venture capital boom is that in the first two cases the under- 
lying trend itself was based on the exploitation of the investors'

bias while in the third it was not. In the case of conglomerates the 
idea was to acquire other companies with inflated paper; in the 
case of REITs the idea was equity leveraging. The idea behind the 
latest generation of technology products had nothing to do with 
the stock market. 
To understand the ups and downs of technology stocks we 
must know something about the underlying trends in technology; 
in the case of conglomerates and mITs we need to know little

else than the theory of reflexivity. 
It is important to realize, however, that knowing everything 
about underlying trends in technology is not sufikient to explain 
the ups and downs of technology stocks: the reflexive interaction 
between underlying trends, prevailing biases, and stock prices 
also needs to be understood. Combining the two kinds of under- 
standifig is extremely difficult. Those who want to be familis 
with technology must follow the industry closely and continu-

ously; those who want to exploit the divergence between percep- 
tion and reality must move from group to group. Most technology 
experts are ignorant of reflexivity and tend to remain fully in- 
vested at all times. Their popularity and influence wax and wane 
in a reflexive fashion. After the recent decline in technology 
stocks, a new breed of analysts seems to be emerging who are 
overly sensitive to the importance of investors' perceptions. After

a decent interval it may be once again profitable to go against the 
prevailing bias and invest in technology stocks on the basis of 
fundamental trends. 
* P.S., February 1987: No longer true after the current explosive rally.

68 Theory 
4 I have always had a lot of difficulty investing in technology 
stocks because of the specialized knowledge required. Finally, I 
managed to gain a good insight into the computer industry during 
the 1975-1976 period and profited from the prevailing negative 
bias. I held on to my positions for a few years but then I sold them 
and lost my grip on the industry. In 1981 I made the mistake of 
not participating in a venture capital fund operated by one of the

most successful venture capitalists of the period in the belief that 
the boom could not last long enough to allow investors to exit in 
time. In this, I was undoubtedly influenced by misgivings about 
the larger picture. In any event, his investors realized a good profit 
in 1963. By that time I was totally out of touch with technology 
stocks and the boom passed me by. 
t Even the conglomerate and REIT sequences were not totally 
self-contained. Extraneous developments, such as the level of

economic activity, regulation, or sGcific events (e.g., the at- 
tempted takeover of Chemical Bank), played a crucial role in the 
conglomerate boom. In less "pure" sequences the importance of 
outside influences is even peafer. 
We are currently in the midst of another self-reinforcinglself- 
defeating cycle that will go down in history as the mergermania 
of the 1980s. Instead of inflated paper, it is cash that serves as the 
currency. The scale of transactions already dwarfs the conglom-

erate boom. Mergermania is but an element in a much larger on- 
going historical drama whose ramifications reach far beyond the 
stock market and involve politics, exchange rates, monetary and 
fiscal policies, quirks of taxation, international capital move- 
ments, and many other developments. 
I shali m~ke an attempt at unraveling the ongoing historical 
drama, but that is not as simple as analyzing a more or less self- 
contained boombust sequence. The larger picture is full of reflex-

ive interactions as well as nonreflexive fundamental trends. We 
need a more complex model that allows for the transition from 
one boombust sequence to another and for the coexistence of 
several reflexive processes at the same time. 
Before I embark on such an ambitious project, I want to exam- 
ine another market that is characterized by vicious and benign 
circles: the currency market.

REFLEXNITY IN THE CURRENCY 
I MARKET* 
While reflexive interactions are intermittent in the stock market, 
they are continuous in the market for currencies. I shall try to 
show that freely floating exchange rates are inherently unstable; 
moreover, the instability is cumulative so that the eventual break- 
down of a freely floqting exchange rate system is virtually as- 
sured. 
The traditional view of the currency market is that it tends

toward equilibrium. An overvalued exchange rat&courages im- 
ports and discourages exports until equilibrium is reestablished. 
Similarly, an improvement in competitive position is reflected in 
an appreciating exchange rate that reduces the trade surplus so 
that equilibrium is again reestablished. Speculation cannot dis- 
rupt the trend toward equilibrium-if speculators anticipate the 
future correctly, they accelerate the trend; if they misjudge it, they

will be penalized by the underlying trend that may be delayed 
but will inexorably assert itself. 
Experience since floating exchange rates were introduced in 
1973 has disproved this view. Instead of fundamentals determin- 
ing exchange rates, exchange rates have found a way of influenc- 
ing the fundamentals. For instance, a strong exchange rate 
discourages inflation: wages remain stable and the price of im- 
ports falls. When exports have a large import component, a coun-

try can remain competitive almost indefinitely in spite of a steady 
* This chapter was written in AprillMay 1985 and revised in December 1986.

70 Theory 
appreciation of its currency, as Germany demonstrated in the 
I 1970s. 
The fact is that the relationship between the domestic inflation 
rate and the international exchange rate is not unidirectional but 
circular. Changes in one may precede changes in the other, but it 
does not make sense to describe one as the cause and the other as 
the effect because they mutually reinforce each other. It is more 
appropriate to speak of a vicious circle in which the currency

depreciates and inflation accelerates or of a benign circle where 
the opposite happens. 
Vicious and benign circles are a far cry from equilibrium. 
NeverthePsss, they could produce a state of affairs akin to equi- 
librium if the reflexive, mutually self-reinforcing relationship 
t could be sustained indefinitely. But that is not the case. The 
self-reinforcing process tends to become more vulnerable the 
longer it lasts and eventually it is bound to reverse itself, setting

in motion a self-reinforcing process in the opposite direction. 
A complete cycle is characterized by wide fluctuations not 
only in the exchange rate but also in interest rates, inflation, 
andlor the level of economic activity. 
The participants' bias introduces an element of instability into 
the system. If the system had an innate tendency toward equilib- 
rium the participants' bias could not disrupt it; at worst, it could 
introduce some random, short-term fluctuations. But when the

causal connections are reflexive, the participants' bias may engen- 
der, sustain, or destroy a vicious or benign circle. Moreover, the 
prevailing bias takes on a life of its own as one of the constituent 
parts in a circular relationship. It finds expression in spec~lative 
capital movements that may serve as a counterweight to an imbal- 
ance in trade, allowing a trade surplus or deficit to exceed, both 
in size and in duration, the level that could have been sustained

in its absence. When that happens speculation becomes a desta- 
bilizing influence. 
International capital movements tend to follow a self-reinforc- 
inglself-defeating pattern similar to the one we identified in the 
stock market. But the model we used for stock price movements 
cannot be applied to currency markets without substantial modi- 
fications. In the stock market we focused on the reflexive relation- 
ship between two variables: stock prices and a single underlying

trend. We were trying to build the simplest possible model and 
we were willing to simplify a much more complex reality to serve

Reflexivity in the Currency Market 7 1 
our purpose. In the currency market we cannot get by with two 
variables; even the simplest model will need seven or eight. We 
have selected four rates and four quantities, namely: 
4 
nominal exchange iate (number of foreign currency units for one 
domestic currency unit; t e = strengthening) 
nominal interest rake 
domestic versus foreign price level ( p = increase in domestic 
prices faster than in foreign prices and vice versa)

level of economic activity 
nonspeculative capital. fl~w 
speculative capital flow = increased inflow 
trade balance t = surplus 
government budget 5. = deficit 
Our task is to establtsh how these variables relate to each other. 
We shall not attempt to explore all the relationships but only 
those that are necessary to build simple models. In other words, 
we are not aiming at a general theory, only at a partial explanation 
of currency movements. Our focus is the exchange rate and we

bring in the other variables only when we need them. We shall 
not quantify any of the variables but only indicate direction 
( , 5. ) or order of magnitude (>, <). A 
Before we start, two general observations can be made. One is 
that relationships tend to be circular; that is, variables can serve 
as both cause and effect in relation to other variables. We shall 
denote the causal connection by 2 horizcntal (+j. The other 
point is that the relationship of .the variables need not be inter-

nally conastent; it is the inconsistencies that make that entire 
situation move in a certain direction, creating vicious or benign 
circles. Equilibrium would require internal consistency; histori- 
cal change does not. Describing historical change in terms of vi- 
cious and benign circles is, of course, merely a figure of speech. 
A circular movement between component parts when the entire 
system is in motion could also be described as a spiral. Moreover,

what is benign and what is vicious are in the eye of the beholder. 
Exchange rates are determined by the demand and supply of 
currencies. For present purposes, we can group the various factors 
that constitute demand and supply under three headings: trade, 
nonspeculative capital transactions, and speculative capital

72 Theory 
transactions. This gives us the simplest model of a freely floating 
4 exchange rate system: 
In other words, the sum of the currency transactions under the 
three headings determines the direction of the exchange rate. 
Our primary interest is in investigating the role that the partic- 
ipants' bias plays in exchange rate movements. To facilitate the 
investigation, we shall assume that the bias finds expression only 
in speculative capital transactions (S], while LiSe (?f and non-

speculative capital flows (N) are independent of expectations: 
4 they constitute the "fundamentals." In reality, the "fundamen- 
tals" are also influenced by the participants' expectations about 
the future course of 'exchange rates. Trade figures are notoriously 
distorted by leads and lags in payment, not to mention the effect 
of expectations on the inventory policy of exporters and import- 
ers. As far as capital movements are concerned, perhaps the only

transaction that is totally independent of expectations is the pay- 
ment of interest on accumulated debt; the reinvestment of interest 
receipts already qualifies as a speculative transaction. The repa- 
triation of bank debt from less developed countries is probably 
best described as nonspeculative, although speculative consider- 
ations come into play if and when the assets are redeployed. What 
about direct investment? If managements were interested only in

the total rate of return, it ought to be classified as speculative, but 
often there are overriding industrial considerations. It can be seen 
that there are many gradations betwee3 speculative and nonspe- 
culative transactions; but we do not do any great violence to real- 
ity by putting them into these two broad categories. 
We shall focus on speculative capital transactions because that 
is where the participants' bias finds expression. Speculative cap-

ital moves in search of the highest total return. Total return has 
three elements: the interest rate differential, the exchange rate 
differential, and the capital appreciation in local currency. Since 
the third element varies from case to case we can propose the 
following general rule: speculative capital is attracted by rising 
exchange rates and rising interest rates.

Reflexivity in the Currency Market 73 
Of the two, exchange rates are by far the more important. It does 
not take much of a decline in the currency to render the total 
return negative. By the same. token, when an appreciating cur- 
rency also offers an interest rate advantage, the total return ex- 
ceeds anything that alholder of financial assets could expect in 
the normal course of events. 
That is not to say tbat interest rate differentials are unimpor-

tant; but much of their importance lies in their effect on exchange 
rates and that depends on the participants' perceptions. There are 
times when relative interest rates seem to be a major influence; at 
other times they are totally disregarded. For instance, from 1982 
to 1986 capital was artacted to the currency with the 2.-,i&est 
interest rate, namely, the dollar, but in the late 1970s Switzerland 
could not arrest the influx of capital even by imposing negative

interest rates. Moreover, perceptions about the importance of in- 
terest rates are often bong. For instance, until November 1984 
the strength of the dollar was widely attributed to high interest 
rates in the United States. When interest rates declined without 
the dollar weakening this view was discredited and the dollar 
went through the roof. 
Expectations about' exchange rates play the same role in cur- 
rency markets as expectations about stock prices do in the stock

market: they constitute the paramount consideration for those 
who are motivated by the total rate of return. In the stock market 
that covers practically all investors, in currency markets all spec- 
ulative transactions. 
In the stock market we used a model that focused on stock 
prices and disregarded dividend income. No great distortion was 
involved because in the kind of boom/"busf sequences we were 
considering stock price movements far outweigh dividend in-

come. Similar conditions prevail in currency markets: expecta- 
tions about future exchange rates constitute the main motivation 
in speculative capital transactions. . 
The major difference between the stock market and the cur- 
rency market seems to be the role played by the fundamentals. 
We have seen that the "fundamentals" were rather nebulous even , 
in the case of stocks but at least we had no reason to doubt that 
stock prices were somehow connected to the fundamentals. In the

case of currencies the trade balance is clearly the most important 
fundamental factor, yet the dollar strengthened between 1982 and 
1985 while the trade balance of the United States was deteriorat-

74 Theory 
ing. It would seem that the fundamentals are even less relevant in 
4 determining price trends than in the stock market. We do not 
need to look far afield for an explanation: it is to be found in the 
relative importance of speculative capital movements. 
As we have seen, speculative capital is motivated primarily by 
expectations about future exchange rates. To the extent that ex- 
change rates are dominated by speculative capital transfers, they

are purely reflexive: expectations relate to expectations and the 
prevailing bias can validate itself almost indefinitely. The situa- 
tion is highly unstable: if the opposite bias prevailed, it could also 
validate itself. The greater the relative importance of speculation, 
+$he more unstable the system becomes: the total rate of return can 
flip-flop with every change in the prevailing bias. 
t In our discussion of the stock market we identified certain se-

quences such as the conglomerate boom where the prevailing bias 
formed an important part of the underlying trend, but we con- 
cluded that such pure mples of reflexivity are exceptional. By 
contrast, in a system of freely fluctuating exchange rates reflexiv- 
ity constitutes the rule. Of course, there is no such thing as a 
purely reflexive situation. Speculation is only one of the factors 
that determine exchange rates and the other factors must also be

taken into account in formulating one's expectations. Thus, ex- 
pectations cannot be totally capricious: they must be rooted in 
something other than themselves. How a prevailing bias becomes 
established and, even more important, how it is reversed are the 
most important questions confronting us. 
There are no universally valid answers. Reflexive processes 
tend to follow a certain pattern. In the early stages, the trend has

.to be self-reinforcing, otherwise the process aborts. As the trend 
extends, it becomes increasingly vulnerable because the funda- 
mentals such as trade and interest payments move against the 
trend, in accordance with the precepts of classical analysis, and 
the trend becomes increasingly dependent on the prevailing bias. 
Eventually a turning point is reached and, in a full-fledged se- 
quence, a self-reinforcing process starts operating in the opposite 
direction.

direction. 
Within this general pattern each sequence is unique. It is the 
characteristic feature of a reflexive process that neither the partic- 
ipants' perceptions nor the situation to which they relate remain 
unaffected by it. It follows that no sequence can repeat itself. Not 
even the variables that interact in a circular fashion need be the

Reflexivity in the Currency Market 75 
same; certainly they will not carry the same weight on different 
occasions. 
We have had two major reflexive moves in the dollar since the 
breakdown of the Bretton Woods system and at least that many in 
sterling. It it instructive to compare the two big moves in the 
dollar because the interaction between the trade balance and cap- 
ital movements was rqically different in the two instances.

In the late 1970s the dollar got progressively weaker, especially 
against the continental currencies, while in the 1980s it got pro- 
gressively stronger. We shall call the first move Carter's vicious 
circle and the second Reagan's benign circle. We can build simple 
models to show how differeni the two trends were. 
In the case of Germany in the late 1970s, the German mark was 
strong ( f e). Speculative purchases played a major role in making

it stronger ( J. S) and sustaining the benign circle. Germany started 
with a trade surplus and the strength of the currency helped to 
keep the price level down. Since exports had a large import con- 
tent the real exchangq rate, as opposed to the nominal, remained 
more or less stable (fep) and the effect on the trade balance was 
negligible (IT). With +e speculative inflow predominating ( J. S > 
fT), the benign circle was self-reinforcing:

fT), the benign circle was self-reinforcing: 
The fact that the rate of currency appreciation exmded the inter- 
est rate differential made it very profitable to hold German marks, 
so that the speculative inflow was both self-reinforcing and self- 
validating. 
'What was a benign circle for Germany was a vicious circie for 
the United States. As the exchange rate depreciated, inflation ac- 
celerated. Despite rising nominal interest rates, real rates re-

mained very low, if not negative. Various measures were tried to 
compensate for the outflow of capital, of which the issue of so- 
called Carter bonds denominated in German marks and Swiss 
francs was the most dramatic, but nothing seemed to work until 
the Federal Reserve embraced a strict monetarist policy. Then 
came the election of Ronald Reagan to the presidency and the 
dollar embarked on a sustained rise. 
During Reagan's benign circle the strong dollar caused a sharp

deterioration in the trade balance of the United States. In contrast 
to Germany in the late 1970s, the United States did not have a

trade surplus to start with. Moreover, the appreciation in the cur- 
I rency was not matched by inflation rate differentials. The infla- 
tion rate declined in the United States but it remained low in 
other countries as well. As a consequence, the United States de- 
veloped an unprecedented trade deficit as well as an unprece- 
dented interest rate differential in favor of the dollar. It was 
extremely attractive to hold dollars as long as the dollar remained

firm, and the dollar remained firm as long as the deficit on current 
account was fully matched by a surplus on capital account. In our 
notation: 
The models are obviously oversimplified. We shall explore Rea- 
gan's benign circle in greater depth later. The point we are trying 
to make here is that different sequences have totally different 
structures. In the case of Germany in the late 1970s the apprecia- 
tion of the currency was sustained by the inflation rate differential

and the balance of trade was largely unaffected. Reagan's benign 
circle was sustained by a differential in interest rates rather than 
inflation rates and there was an ever-growing trade deficit which 
was matched by an ever-growing inflow of capital. While in the 
first case it was possible to claim some kind of equilibrium, in the 
second case the disequilibrium was palpable. The inflow of capi- 
tal depended on a strong dollar and a strong dollar depended on

an ever-rising inflow of capital which carried with it ever-rising 
interest and repayment obligations ( T N). It was obvious that the 
benign circle could not be sustained indefinitely. Yet, while it 
iasted, any cummcy speculator who dared to fight the trend had 
to pay dearly for it. Speculation did not serve to reestablish equi- 
librium. On the contrary, it reinforced the trend and thereby in- 
creased the disequilibrium, which would eventually have to be 
corrected. . .

corrected. . . 
Although each self-reinforcing circle is unique, we can make 
some universally valid generalizations about freely fluctuating 
exchange rates. First, the relative importance of speculative trans- 
actions tends to increase during the lifetime of a self-reinforcing 
trend. Second, the prevailing bias is a trend-following one and 
the longer the trend persists, the stronger the bias becomes. The 
third is simply that once a trend is established it tends to persist

and to run its full course; when the turn finally comes, it tends to

Reflexivity in the Currency Market 7 7 
set into motion a self-reinforcing process in the opposite direc- 
tion. In other words, currencies tend to move in large waves, with 
each move lasting several years. 
These three tendencies are mutually self-validating. It is the 
growth in speculative ;capital flows moving in a trend-following 
fashion that makes the trend so persistent; it is the persistence of 
the trend that makes a trend-following bias so rewarding; and it

is the rewards reaped by speculation that attract increasing 
amounts of capital. 
The longer a benign circle lasts, the more attractive it is to hold 
financial assets in the appreciating currency and the more impor- 
tant the exchange rate'becomes in calculating total return. Those 
who are inclined to fight the trend are progressively eliminated 
and in the end only trend followers survive as active participants. 
As speculation gains in importance, other factors lose their influ-

ence. There is nothing to guide speculators but the market itself, 
and the market is dominated by trend followers. These consider- 
ations explain how thk dollar could continue to appreciate in the 
face of an ever-rising trade deficit. Eventually, a crossover point 
would have been reached, even without the intervention of the 
authorities, when the inflow of speculative funds could not keep 
pace with the trade deficit and with rising interest obligations,

and the trend would have been reversed. Since the predominating 
bias is trend following, speculative capital would then have 
started moving in the opposite direction. If and %en that hap- 
pened, the reversal could easily have accelerated into a free fall. 
For one thing, speculation and "fundamental" flows would then 
have worked in the same direction. Even more important, when a 
change in trend is recognized, the volume of speculative transae-

tions is likely to undergo a dramatic, not to say catastrophic, 
increase. While a trend persists, speculative flows are incremen- 
tal; but a reversal involves not only the current flow but also the 
accumulated stock of speculative capital. The longer the trend 
has persisted, the larger the accumulation. There are, of course, 
mitigating circumstances. One is that market participants are 
likely to recognize a change in trend only gradually. The other is

that the authorities are bound to be aware of the danger and do 
something to prevent a crash. How the drama actually unfolded 
will be the subject of a later chapter. Here we are trying to estab- 
lish a general proposition. 
Taking the three generalizations together, it can be asserted that

78 Theory 
I speculation is progressively destabilizing. The destabilizing effect 
arises not because the speculative capital flows must be even- 
tually reversed but exactly because they need not be reversed 
until much later. If they had to be reversed in short order, capital 
transactions would provide a welcome cushion for making the 
adjustment process less painful. If they need not be reversed, the 
participants get to depend on them so that eventually when the

turn comes the adjustment becomes that much more painful. 
It is quite likely that the generalization about the progressive 
accumulation of hot money holds true not only within a cycle but 
also from one cycle to another, although the history of fluctuating 
exchange rates is too short to provide reliable evidence. It has 
certainly been true so far-the size of speculative capital move- 
I ments was far greater in Reagan's benign circle than it was during

Carter's vicious circle. Empirical studies of the 1930s also showed 
a cumulative growth in "hot money" movements,' although cir- 
cumstances were somewhat different because currencies were not 
freely floating. 
We can see why hot money should continue to accumulate as 
long as real interest rates are high and the return on physical 
investments low: keeping capital in liquid fonn in an appreciat; 
ing currency is more rewarding than investing it in physical as-

sets. What is needed to give the generalization universal validity 
is an argument that would show that fluctuating exchange rates 
are associated with high returns on financial assets and low re- 
turns on physical investments. Let me try. We have seen that hot 
money can earn exceptional returns if it gets the trend right; since 
it sets the trend, that is likely to be the case. Physical assets rep- 
resent the opposite side of the coin: they cannot move to take

advantage of the trend. The tradable goods sector is bound to 
suffer when a currency appreciates. Of course, a depreciating cur- 
rency brings windfall profits to exporters, but having been hurt 
before, exporters are loath to invest on the basis of a temporary 
advantage: they prefer to hold their profits in financial assets, 
contributing to the growth of hot money. The process can be most 
clearly observed in the United Kingdom, where exporters refused

to expand when sterling fell below $1.10 in 1985, despite record 
profits. How right they were! Sterling rose above $1.50 by April 
1986. Thus, both an appreciating currency and a depreciating 
currency discourage physical investment and foster the accumu- 
lation of "hot money."

Reflexivity in the Currency Market 79 
We can attempt yet banother tentative generalization. When a 
long-term trend loses its momentum, short-term volatility tends 
to rise. It is easy to see why that should be so: the trend-following 
crowd is disoriented. The generalization is tentative because it is 
based on inadequate evidence. It certainly was true when the 
dollar reversed its trend in 1985.2 
If these generalizations are indeed valid, the eventual demise of

a system of freely fluctuating exchange rates is inevitable. Fluc- 
tuations become so wild that either the system has to be modified 
by some kind of government intervention or it is bound to break 
down. Currency markets thus provide the best support for my 
contention that financial markets are inherently unstable. There 
is no built-in tendency toward equilibrium: to the extent that we 
need stability we must introduce it by deliberate policy measures.

These conclusions may not strike the reader as particularly rev- 
olutionary at the present time, but they certainly contradicted the 
prevailing wisdom at ,the time they were written in Aprilt'ay 
1985. There was widespread malaise about the instability of ex- 
change rates, but belief in the magic of the market was still run- 
ning strong, and the famous Plaza agreement in September 1985 
came as something of a shock to market participants. Even today,

there is no theoretical underpinning for the contention that a 
freely floating exchange rate system is cumulatively destabilizing. 
That is what I hope to have provided here. & 
I have been speculating in currencies ever since they started 
floating, but I have failed to make money on a consistent basis. 
On balance, I traded profitably tluough 1980 and then chalked up 
losses between 1981 and 1985. My approach has been tentative, 
based more on intuition than on conviction. By temperament, I

have always been more interested in picking the turning point 
than in following a trend. I managed to catch both the rise and 
fall of European currencies against the dollar until 1981, but I 
traded myself out of my positions too soon. Having lost the trend, 
I found it too demeaning to start following the trend-followers; I 
tried to pick the reversal point instead-needless to say, without 
success. I had so-me temporary profits in the early part of 1984,

but I gave them all back. 1 was again engaged in a speculation 
against the dollar at the time I wrote this chapter [AprilJMay 
1985). Writing it has undoubtedly helped to clarify my thoughts. 
The real-time experiment recorded in Part 111 may be regarded

80 Theory 
, as a practical test of the theory propounded here. Admittedly the 
theory is far too abstract to be of much use in making concrete 
predictions. Specifically, the turning point cannot be determined 
until it has actually occurred. But, as we shall see, the theory can 
be very useful in interpreting events as they unfold.

THE CREDlT AhW REGULATORY CYCLE * 
There seems to be a special affinity between reflexivity and credit. 
That is hardly surprising: credit depends on expectations; expec- 
tations involve bias; hdnce credit is one of the main avenues that 
permit bias to play a causal role in the course of events. But there 
is more to it. Credit seems to be associated with a particular kind 
of reflexive pattern that is known as boom and bust. The pattern

is asymmetrical: the boom is drawn out and accelerates gradually; 
the bust is sudden and often catastrophic. By contrast, when 
credit is not an essential ingredient in a reflexitlreprocess, the 
pattern tends to be more symmetrical. For instance, in the cur- 
rency market it does not seem to make much difference whether 
the dollar is rising or falling: the exchange rate seems to follow a 
wavelike pattern. 
I believe the asymmetry arises out of a reflexive connection

between loan and collateral. In this context I give collateral a very 
broad definition: it will denote whatever determines the credit- 
worthiness of a debtor, whether it is actually pledged or not. It 
may mean a piece of property or an expected future stream of 
income; in either case, it is something on which the lender is 
willing to place a value. Valuation is supposed to be a passive 
relationship in which the value reflects the underlying asset; but

in this case it involves a positive act: a loan is made. The act of 
lending may affect the collateral value: that is the connection that 
gives rise to a reflexive process. 
* Written in August 1985. 
81

82 Theory 
It will be recalled that we have analyzed reflexivity as two con- 
nections working in opposite directions: the "normal" connec- 
tion where a value is placed on future events, as in the stock 
market or banking-we have called it the cognitive function; and 
a "perverse" connection in which expectations affect that which 
is expected-we have called it the participating function. The 
participating function is perverse because its effect is not always

felt, and when it does operate its influence is so difficult to dis- 
entangle that it tends to go unrecognized. The prevailing view of 
how financial markets operate tends to leave the participating 
function out of account. For instance, in the international lending 
boom, bankers did not recognize that the debt ratios olr borrowing 
countries were favorably influenced by their own lending activ- 
ity. In the conglomerate boom, investors did not realize that per-

share earnings growth can be affected by the valuation they place 
on it. At present, most people do not realize that the erosion of 
collateral values can depress the economy. 
The act of lending usually stimulates economic activity. It en- 
ables the borrower to consume more than he would otherwise, or 
to invest in productive assets. There are exceptions, to be sure: if 
the assets in question are not physical but financial ones, the

effect is not necessarily stimulative. By the same token, debt ser- 
vice has a depressing impact. Resources that would otherwise be 
devoted to consumption or the creation of a future stream of in- 
come are withdrawn. As the total amount of debt outstanding 
accumulates, the portion that has to be utilized for debt service 
increases. It is only net new lending that stimulates, and total 
new lending has to keep rising in order to keep net new lending 
stable.

stable. 
The connection between lending and economic activity is far 
from straightforward (that is, in fact, the best justification for the 
monetarists' preoccupation with money supply, to the neglect of 
credit). The major difficulty is that credit need not be involved in 
the physical production or consumption of goods and services; it 
may be used for purely financial purposes. In this case, its influ- 
ence on economic activity becomes problematic. For purposes of

this discussion it may be helpful to distinguish between a "real" 
economy and a "financial" economy. Economic activity takes 
place in the "real" economy, while the extension and repayment 
of credit occur in the "financial" economy. The reflexive interac- 
tion between the act of lending and the value of the collateral may

The Credit and Regulatory Cycle 83 
then connect the "real" and the "financial" economy or it may be 
confined to the "financitil" economy. Here we shall focus on the 
first case. 
A strong economy tends to enhance the asset values and income 
streams that serve to determine creditworthiness. In the early 
stages of a reflexive prdcess of credit expansion the amount of 
credit involved is relatively small so that its impact on collateral

values is negligible. Thdt is why the expansionary phase is slow 
to start with and credit remains soundly based at first. But as the 
amount of debt accumulates, total lending increases in impor- 
tance and begins to have an appreciable effect on collateral val- 
ues. The process continves until a point is reached where total 
credit cannot increase fast enough to continue stimulating the 
economy. By that time, collateral values have become greatly de-

pendent on the stimulative effect of new lending and, as new 
lending fails to accelerate, collateral values begin to decline. The 
erosion of collateral values has a depressing effect on economic 
activity, which in turn reinforces the erosion of collateral values. 
Since the collateral has'been pretty fully utilized at that point, a 
decline may precipitate the liquidation of loans, which in turn 
may make the decline more precipitous. That is the anatomy of a ' 
typical boom and bust.

typical boom and bust. 
Booms and busts are not symmetrical because, at the inception 
of a boom, both the volume of credit and the value of the collateral 
are at a minimum; at the time of the bust, both are ap maximum. 
But there is another factor at play. The liquidation of loans takes 
time; the faster it has to be accomplished, the greater the effect on 
the value of the collateral. In a bust, the reflexive interaction be- 
tween loans and collateral becomes compr~ssed within a very

short time frame and the consequences can be catastrophic. It is 
the sudden liquidation of accumulated positions that gives a bust 
such a different shape from the preceding boom. 
It can be seen that the boomhust sequence is a particular var- 
iant of reflexivity. Booms can arise whenever there is a two-way 
connection between values and the act of valuation. The act of 
valuation takes many forms. In the stock market, it is equity that

is valued; in banking, it is collateral. It is possible, although un- 
likely, that a boom could be generated without any credit expan- 
sion. The two examples we studied in the stock market, the REIT 
and conglomerate booms, could, in theory, have unfolded with- 
out the stocks being used as collateral, although in practice there

84 Theory 
was a lot of credit involved. In the absence of credit the reversal 
t would be a more gradual process. The contraction would not be a 
mirror image of the expansion for the reason mentioned earlier- 
the reflexive element in valuations is greater at the time of rever- 
sal than at the inception of a trend-but the compression that is 
characteristic of busts would be absent. 
Both the boodust pattern and its explanation are almost too

obvious to be interesting. The amazing thing is that the reflexive 
connection between lending and collateral has not been generally 
recognized. There is an enormous literature on the trade cycle, 
but I have not seen much awareness of the reflexive relationship 
described here. Moreover, the trade cycles that-are gemrally dis- 
cussed in textbooks differ in duration from the credit cycle I am 
discussing here: they are short-tenn fluctuations within a larger

t pattern. There is an awareness of a larger cycle, usually referred 
to as the Kondratieff wave,-but it has never been "scientifically" 
explained. At present, there is much concern that we may be 
approaching another recession but the general assumption is that 
we are dealing with a recession just like any other; the fact that 
we are in the declining phase of the larger cycle is usually left out 
of account. I contend that all previous recessions since the end of

World War 11 occurred while credit was expanding, while the one 
we may or may not be facing now would occur when borrowing 
capacity in the real economy is contracting. This creates a situa- 
tion that has no precedent in recent history. 
Exactly where we are in the larger cycle is difficult to deter- 
mine. I must confess I have been confused on the issue since 1982. 
The reason for my confusion is that while the boom has clearly 
' sun out of steam, the bust has not taken place.

Busts can be very disruptive, especially if the liquidation of 
collateral causes a sudden compression of credit. The conse- 
quences are so unpleasant that strenuous efforts are made to avoid 
them. The institution of central banking has evolved in a continu- 
ing attempt to prevent sudden, catastrophic contractions in 
credit. Since a panic is hard to arrest once it has started, preven- 
tion is best practiced in the expansionary phase. That is why the

role of central banks has gradually expanded to include the regu- 
lation of the money supply. That is also why organized financial 
markets regulate the ratio of collateral to credit. 
Until now, the authorities have been able to prevent a bust. We 
find ourselves in a twilight zone where the "normal" process of

The Credit and Regulatory Cycle 85 
credit expansion culminated long ago but the "normal" process 
of credit contraction has been prevented by the authorities. We 
are in uncharted territory because the actions of the authorities 
have no precedent. 
The fact that banks and organized financial markets are regu- 
lated complicates the Course of events tremendously. Financial 
history is best interpreted as a reflexive process in which there

are two sets of participants instead of one: competitors and regu- 
lators. 
Such a system is much more complex than the case we studied 
in the stock market. There, the regulatory environment was more 
or less fixed: it was the backdrop against which the drama was 
acted out. Here, the regulatory environment is an integral part of 
the process. 
~t is important to realize that-the regulators are also partici- 
pants. There is a natural tendency to regard them as superhuman

beings who somehow stand outside and above the economic pro- 
cess and intervene only when the participants have made a mess 
of it. That is not the case. They also are human, all too human. 
They operate with imperfect understanding and their activities 
have unintended consequences. Indeed, they seem to adjust to 
changing circumstances less well than those who are motivated 
by profit and loss, so that regulations are generally designed to

prevent the last mishap, not the next one. The deficiencies of 
regulation tend to be more noticeable when conditi~s are rapidly 
changing, and conditions tend to change more rapidly when the 
economy is less regulated. 
We begin to discern a reflexive relationship between the regu- 
lators and the economy they regulate. It gives rise Po a process 
that takes place concurrently with the process of credit expansion 
and contraction and interacts with it. It is no wonder that the

result is so complex and perplexing! 
The regulatory cycle does not have the asymmetric character of 
the credit ~ycle. It seems to fit the wave pattern we developed for 
the currency market better than the boom and bust pattern of the 
credit cycle. Just as freely floating currencies tend to fluctuate 
between over- and undervaluation, so market economies tend to 
fluctuate between over- and underregulation. The length of the 
cycle seems to be correlated with the credit cycle and one can

sense intuitively why that should be so. Credit expansion and 
contraction have much to do which changes in the economy,

86 Theory 
which in turn have a bearing on the adequacy of regulations. 
, Conversely, the regulatory environment influences not only how 
fast credit can expand but also how far. Clearly, there is a two- 
way connection between credit and regulation, but it is far from 
clear to me at this stage of the investigation what pattern, if any, 
the interaction follows. That is the main source of my confusion. 
We have identified a credit cycle that follows a boom/bust pat-

tern: a regulatory cycle that is more wavelike, and an interplay 
between the two whose pattern is unclear. There are, of course, 
many secular developments involved as well, some of which re- 
late to credit, some to regulation, and some to both. We have 
mentioned that central banks tend to get stronger after each crisis; 
that is a secular development that renders each cycle unique. In 
the Great Depression both the banking system and the interna-

4 tional trading system collapsed, making the contraction of credit 
and economic activity much more severe than it would have been 
otherwise. We can be certain that every effort will be made to 
avoid a similar collapse in this cycle. We did not dwell on the 
information revolution or on the improvements in transportation 
that have helped the development of an integrated world econ- 
omy. The outcome of all these influences is a unique course of

events that is easier to explain than to predict. 
Looked at from this perspective, the entire postwar period is 
part of a large expansionary boom that is now well advanced and 
ripe for a bust. The bust has been avoided, however, by the inter- 
vention of the authorities at crucial moments. The interplay be- 
tween government actions and the market mechanism has given 
rise to a unique constellation that I have called Reagan's Imperial

Circle. We are now at the crucial moment where the Imperial 
Circle is beginning to unwind and the au+thorities must invent 
another solution to forestall a bust. 
The same postwar period has also seen an almost complete 
swing from government regulation to unrestrained competition. 
We are now at a curious moment where the bias in favor of dereg- 
ulation is still on the rise yet the need for government interven- 
tion in specific areas is beginning to reassert itself. The banking

industry, for one, is already on the way to becoming more regu- 
lated. 
One could try and write a history of the postwar era in these 
terms. The present credit cycle started after the end of World War 
11; the origins of the regulatory cycle go back even farther to the

The Credit and Regulatory Cycle 87 
New Deal, although the creation of the Bretton Woods system can 
be taken as the starting point as far as the world economy is 
concerned. The expansion that followed was intimately related to 
the removal of restrictions on international trade and investment. 
But international capital movements created problems for the 
Bretton Woods system that were never anticipated and remain 
unresolved. 
I shall not attempt to present the complete story here. 1 shall

start at the point where I became actively involved and I shall 
follow the path of my own involvement. This will give the inves- 
tigation a more experimental character. 
My experiences began after the breakdown of the system of 
fixed exchange rates in 1973. Relationships that had been fixed 
became subject to reflexive influences and my interest veered 
from specific companies and industries to macroeconomic pro- 
cesses. My study of "growth banks" in 1972 constituted a transi-

tion point, although I did not know it at the time. 
With the passage of time I found the instability of macroecon- 
omic trends increasingly disturbing in both a subjective and an 
objective sense and I decided to distance myself from active in- 
vesting in 1981. After the crisis of 1982 I made a theoretical study 
of the international debt problem. I was under the mistaken 
impression that the crisis of 1982 constituted the climax in the

process of credit expansion. I thought that the authorities were 
not doing enough to prevent a bust; I failed to regize that they 
were doing too much. They actually kept credit expanding, albeit 
on a more unsound basis than ever. The United States replaced 
less developed countries as the "borrower of last resort" and com- 
mercial banks tried to grow their way out of the loans made ta 
less developed countries by aggressively expanding in other di-

rections. This led to another series of crises in 1984 that consti- 
tuted the real turning point for the banking and thrift industries. 
We are now suffering from the aftereffects of that climax. The 
United States government continues to borrow on an ever- 
increasing scale, but here, too, a turning point is at hand. The 
dollar has begun to decline and foreigners are going to be repaid 
in a depreciating currency. Perhaps the last great engine of credit

creation that is still going full blast is in the stock market where 
mergermania is at its peak; but it does not have a stimulating 
effect on the real economy. 
The theoretical framework of an interrelated credit and regula-

88 Theory 
tory cycle became somewhat clearer to me in the course of writing 
I this book, although I cannot claim that the process of clarification 
is complete. Nevertheless, I felt it was appropriate to summarize 
it at this point. I shall now use the theoretical framework outlined 
here to explain the course of events since 1972. The reader should 
be advised that the writing of the explanation predates the for- 
mulation of this admittedly tentative theoretical framework.

P. S., DECEMBER 1986 
Having completed the explanation, I engaged in a real-time exper- 
iment from August 1985 to the end of 1986, trying to predict th.e 
evolution of the credit and regulatory cycle. I came to a strange 
conclusion. It appears that the cycle got stuck in 1982. If it had 
4 not been for the successful intervention of the monetary authori- 
ties, the international debt crisis would have led to a collapse of 
the banking system. As it is, the collapse has been avoided, but

the genuine trend reversal which it would have ushered in also 
failed to take place. We now live in a system where we contin- 
ually go to the brink and then recoil when we see the abyss open- 
ing up at our feet. The cohesion we manage to muster in the sight 
of a disaster tends to disintegrate as soon as the danger recedes, 
and the process then repeats itself in different forms. We can 
observe it in international lending; in the U.S. budget deficit; in

the international monetary system; in OPEC; in the banking sys- 
tem; in financial markets; and 1987 will undoubtedly be the year 
when protectionism drives the international trade system to the 
brink of collapse but probably not beyond it.

THE INTERNATIONAL DEBT PROBLEM 
The greatest problem in *eflexivity analysis is to decide what ele- 
ments to single out for attention. In dealing with a financial mar- 
ket the problem is relatjvely simple. The critical variable is the 
market price and the elements that need to be considered are 
those that influence market prices. But even here the number of 
factors that may come into play is almost infinite. Using just one 
underlying trend and one predominant bias is an oversimplifica-

tion that may be useful in demonstrating the dynamics, not to say 
dialectics, of a historical process, but it is totally inadequate to 
explain, let alone predict, the actual course of events? 
When we venture outside the confines of a particular market, 
the problem of selection is even more complex. We need a set of . 
interacting components that can explain the phenomenon we are 
dealing with. But there may be different sets that could explain

the same phenomenon and we can have no assurance that we 
have selected the right one. The plethora of potential components 
is particularly troubling when we try to predict the future course 
of events: we do not know which one will become significant. 
The boom and bust in international lending is a case in point. 
It is an indispensable element in the current economic situation. 
Taken by itself, it constitutes an almost perfect example of a

boomhust sequence. Looked at in the context of the overall situ- 
ation, it is just one of many elements that need to be taken into 
account. To complicate matters, the international debt problem 
has played a crucial role in the evolution of the banking system, 
and the evolution of the banking system is also a reflexive process

92 Historical Perspective 
that is significant in itself as well as being a significant element in 
I the overall situation. 
What is, then, the best way to deal with international lending? 
One has to consider the subject from at least three points of view: 
as a reflexive phenomenon in its own right; as a factor in the 
evolution of the banking system; and as part of the current eco- 
nomic situation. I shall try to consider all three at the same time

because that is the only way to avoid undue repetition. By choos- 
ing this route, I shall also provide a practical demonstration of 
the complexity of reflexive processes in the real world. It goes 
without saying that the analysis is not an easy one to follow; but 
I shall try to keep the three points sf view separate as we go dong. 
Some degree of distortion is inevitable: since we are interested in 
I the evolution of the banking system, we shall pay more attention

to the lenders than the borrowers. If we wanted to explore the fate 
of the less developed countries, we would have to shift our focus. 
The origins of the international lending boom go back at least 
as far as the first oil shock in 1973; but to discuss the evolution of 
the banking system we have to go back even farther, and to under- 
stand the economic cycle that has dominated recent history we 
ought to start with the breakdown of the Bretton Woods system

in 1971. That would take us too far back; so I shall take early 1972 
as my starting point, and I shall begin by looking at the banking 
system in the United States. As it happens, that is the date of a 
stock market report I wrote entitled "The Case for Growth Banks." 
Banks at the time were considered the stodgiest of institutions. 
Managements had been traumatized by the failures of the 1930s 
and safety was the paramount consideration, overshadowing

profit or growth. The st~dcture of the industry was pracirical'ly 
frozen by regulation. Expansion across state lines was prohibited 
and in some states even branch banking was outlawed. A dull 
business attracted dull people and there was little movement or 
innovation in the industry. Bank stocks were ignored by investors 
looking for capital gains. 
Underneath the calm surface, changes were brewing. A new 
breed of bankers was emerging who had been educated in busi-

ness schools and thought in terms of bottom-line profits. The 
spiritual center of the new school of thinking was First National 
City Bank of New York, and people trained there were fanning 
out and occupying top spots at other banks. New kinds of finan- 
cial instruments were being introduced, and some banks were

The International Debt Problem 93 
beginning to utilize their capital more aggressively and putting 
together very creditabld earnings performances. There were some 
acquisitions within state limits, leading to the emergence of larger 
units. The larger banks typically leveraged their equity 14 to 16 
times, with the Bank oflAmerica running as high as 20 times. The 
better banks showed a keturn on equity in excess of 13%. In any 
other industry, such a ceturn on equity, combined with per-share

earnings growth of better than 10% would have been rewarded 
by the shares selling at a decent premium over asset value, but 
bank shares were selling at little or no premium. Analysts of bank 
shares were aware of this relative undervaluation but they de- 
spaired of seeing the situation corrected because the underlying 
changes were too gradual and the prevailing valuation too stable. 
Yet, many banks had reached the point where they were pushing

against the limits of what was considered prudent leverage by the 
standards of the time. 'If they wanted to continue growing they 
would need to raise additional equity capital. 
It was against this background that First National City hosted a 
dinner for security analysts-an unheard-of event in the banking 
industry. I was not invited but it prompted me to publish a report 
that recommended purchase of a bouquet of the more aggressively

managed banks. It documented the situation I have described here 
and it argued that bank stocks were about to come alive because 
managements had a good story to tell and they had started telling 
it. "Growth" and "banks" seemed like a contradicthn in terms, I 
wrote, but the contradiction was about to be resolved by bank 
' shares being awarded growth multiples. 
Banks stocks did, in fact, have a good move in 1972 and we 
made aSou4 50% on our bouquet. Some of the more alert banks

managed to raise some capital. If the process of raising capital at 
a premium over book value had become established, banks could 
have expanded on a sound basis and the evolution of the banking 
system would have taken a different course. As it happened, the 
process had hardly started when inflation accelerated, interest 
rates rose, and a 13% return on capital was no longer sufficient to 
enable banks to sell shares at a premium.

enable banks to sell shares at a premium. 
Then came the aftermath of the first oil shock and a tremendous 
increase in the flow of funds to the oil-producing countries. These 
countries did not know what to do with the money and it piled 
up in the banks. A point was reached when some banks, like 
Bankers Trust, felt obliged to turn away deposits. How to recycle

94 Historical Perspective 
these so-called petrodollars became a major problem. There were 
active discussions about intergovernmental schemes but nothing 
much came out of them except for some increased Saudi contri- 
butions to the IMF and th;! World Bank. The governments of the 
industrialized world failed dismally to rise to the occasion and it 
was by default that the recycling of petrodollars was left to the 
banks. 
The banks stepped into the breech and fulfilled their function

all too well. Flush with funds, they became aggressive lenders, 
and they found plenty of takers. Less developed countries with- 
out oil sought to finance their deficits by running up large debts; 
thoss with oil embarked on an~bitious expansion programs, 
which they financed by borrowing on the strength of their oil 
I reserves. This was the time of detente, which meant that Eastern 
European countries borrowed huge amounts from Western banks

in the hope of repaying them using the products of the factories 
they built with borrowed money. That is how the international 
lending boom began. 
At first, the banks were recycling the OPEC surplus. As time 
passed, the oil-rich countries found other ways of utilizing their 
new-found wealth: acquiring the most sophisticated armaments, 
expanding their economy at a breakneck pace, buying diamonds 
and real estate, and making other long-term investments. Mean-

while, demand for bank financing continued to build. Increas- 
ingly, the banks became the source of credit. Each loan created 
deposits elsewhere so that the banks were able to generate the 
funds they were lending by their own activity. Since the Eurodol- 
lar market was not regulated, banks did not have to maintain 
minimum reserve raquirements against the liabilities of their off- 
shore affiliates. There was nothing to stop those affiliates from

creating a seemingly unlimited supply of credit except self-re- 
straint. 
But international lending was too profitable to leave much 
room for caution. Business could be transacted on a large scale, 
the risk of adverse interest rate movements could be minimized 
by the use of floating rates, and administrative costs were much 
lower than in the case of corporate loans. Fierce competition kept 
spreads between borrowing and lending rates quite narrow;

nevertheless, international lending became one of the easiest and 
most profitable forms of banking activity, attracting many banks 
with no previous experience in the field. The number of banks

The International Debt Problem 95 
represented in London grew greatly during this period, and inter- 
national lending became the fastest growing sector of the banking 
industry. Naturally, if banks had set up reserves that would have 
been appropriate in the light of subsequent experience, the 
business would not hafre been as profitable as it seemed at the 
time. I I 
The external shape ,of the U.S. banking industry remained 
largely stagnant duringlthis period. Expansion by way of mergers

and acquisitions was strictly circumscribed by regulation. But the 
internal structure of banks underwent considerable transforma- 
tion. The main corporate trend was the formation of bank holding 
companies. The change of format allowed additional leveraging 
at the holding company level so that the ratio of capital to total 
assets continued to deteriorate. Moreover, the so-called Edge Act 
subsidiaries escaped some of the regulatory restrictions imposed

on banks. The greatest scope was abroad. Accordingly, most of 
the corporate moves were international with American banks ex- 
panding abroad and foreign banks establishing footholds in the 
United States. For instance, more than a quarter of Citicorp's earn- 
s came from Brazil. 
t was also a time ofl rapid technological innovations. The use i7 
of computers speeded up activities and permitted operations that 
would have been previously inconceivable. Many new financial

instruments and financing techniques were invented and banking 
became a much more sophisticated business than it had been only 
a decade ago. These trends continue at an accelerae pace to the 
present day. 
The task of the regulators was complicated both by the pace of 
ianovation and by the international character of the competition. 
It is not unfair to say that the regulators were always lagging a 
step behind the practitioners and the industry became adept at

finding a way around whatever regulations were imposed. 
In the international arena the authorities did not want to hinder 
their own industry from competing on equal terms. With no reg- 
ulatory constraints and individual banks competing for market 
share, the market as a whole grew by leaps and bounds. Banks 
were so anxious to obtain business that they asked very few ques- 
tions. It is amazing how little information borrowing countries

had to supply in order to obtain loans. Lending banks did not 
even know how much money the countries in question were bor- 
rowing elsewhere.

96 Historical Perspective 
Debtor countries preferred to deal with commercial banks 
I rather than go to the International Monetary Fund when they 
were in balance-of-payments difficulties. Unwittingly, commer- 
cial banks took over one of the functions that the Bretton Woods 
institutions-the IMF and the World Bank-had been designed 
to fulfill. They tranferred resources to less developed countries 
on a much larger scale than the Bretton Woods institutions would

have been willing to countenance, and with much less interfer- 
ence in the debtor countries' affairs. No wonder that less devel- 
oped countries stayed away from the IMF! Mainly industrialized 
countries like the United Kingdom asked for support from the 
IMF; developing co~ntries could do better with co~rm~ercial 
banks. There was a veritable explosion of international credit be- 
I tween 1973 and 1979. It was the foundation of the worldwide

inflationary boom of the 1970s, which eventually culminated in 
the second oil shock. 
In retrospect it is obvious that the borrowers spent the money 
unwisely. At best they built white elephants like the Itaipu Dam 
in Brazil; at worst they spent it on armaments or used it to main- 
tain unrealistically high exchange rates as in the "southern cone" 
countries of Argentina and Chile. At the time, the folly was not 
recognized. Indeed, Brazil was regarded as an economic miracle

and Chile was praised as a paragon of monetarist virtue. 
International lending grew so rapidly that the banks involved 
became overextended: their capital and reserves could not keep 
pace with the growth of their balance sheets. But the quality of 
their loan portfolios remained sound-at least outwardly. Indeed, 
one of the most striking features of the situation was that the 
borrowing countries continued to meet the traditional yardsticks

used to determine their creditworthiness even as their overall 
debt burden grew at an alarming rate. 
Banks use ratios-such as external debt as a percentage of ex- 
ports, debt service as a percentage of exports, and current deficits 
as a percentage of exports-to measure creditworthiness. The in- 
ternational lending activity of the banks set in motion a self-rein- 
forcing and self-validating process that increased the debt-

servicing ability of the debtors, as measured by these ratios, al- 
most as fast as their debt. 
The key to the process is to be found in the very low and, 
eventually, negative real interest rates that prevailed during the 
1970s. Since the Eurocurrency market was outside the control of

The International Debt Problem 97 
the central banks, its growth did not directly influence monetary 
policy in any country. As the banks graduated from recycling 
OPEC surpluses to creating credit, the monetary policy of the 
United States remained relaxed. The dollar started to depreciate, 
and interest rates failed to keep up with the rise in prices. The 
decline in real interesi rates lowered the cost of debt service and 
rendered the borrowing countries more creditworthy. It also made

them more eager to bbrrow. The expansion of credit stimulated 
the world economy and helped export performance all around. 
The less developed countries enjoyed strong demand for the com- 
modities they exported; thus their terms of trade also tended to 
improve. The combination of declining real interest rates, ex- 
panding world trade, improving commodity prices, and the de- 
preciating dollar enabled and encouraged the debtor countries to 
increase their indebtedness.

increase their indebtedness. 
The self-validating process of credit expansion-inflation for 
short-was unsound in more ways than one. Prices and wages 
rose at accelerating rates. Balance-of-payments deficits and sur- 
pluses were perpetuated. The balance sheets of the banks deteri- 
orated. Much of the investment activity financed by bank lending 
- was misdirected. The creditworthiness of the debtors was illu- 
sow Yet, as long as the process validated itself, the world econ-

omy prospered. Consumption remained high while saving was 
discouraged by low or negative interest rates. Investment was 
stimulated by the availability of cheap loans, there was a 
flight from monetary to real assets. The combination of high con- 
sumption, high inventories, and strong investment activity cre- 
ated boom conditions. 
The boom kept the demand for energy growing. The OPEC 
countries grew richer and less in need of current income, while

negative real interest rates made it more attractive to keep oil in 
the ground than cash in the bank. This provided the setting in 
which the disruption of Iranian production in 1979 caused a sec- 
ond crisis and a second jump in the price of oil. 
This time the response was different. Inflation had become a 
dominant concern, especially in the United Kingdom and the 
United States. Continental Europe and Japan had escaped the rav-

ages of inflation by following a more restrictive monetary policy 
and allowing their currencies to appreciate. Since the price of oil 
is fixed in dollars, the cost of oil to Europe and Japan fell, and, in 
the absence of inflation, their exports remained competitive de-

98 Historical Perspective 
spite the appreciation of their currencies. The United Kingdom 
and the United States, by contrast, developed large budgetary and 
trade deficits, and inflation became a serious problem. Britain had 
to turn to the IMF for help. The United States, controlling as it 
did the reserve currency of the world, could inflate with impu- 
nity; nevertheless, the domestic and international consequences 
of inflation led to a shift in political preferences. The specter of

accelerating inflation took precedence over the fear of recession. 
In response to the second oil shock, monetary policy turned re- 
strictive and remained so even after the economy started to de- 
cline. 
Monetarism became the doctrine that guided eeonornic policy. 
Previously, central banks sought to influence economic activity 
I by controlling interest rates; now the emphasis shifted to control- 
ling the quantity of money. Interest rates were allowed to find

their own level. Unfortunately, the level they found was inordi- 
nately high. The main reason was that fiscal policy remained 
stimulative, and it required a highly restrictive monetary policy 
to keep the growth in money supply in check. 
Fiscal policy was influenced by supply-side economics. It was 
believed that lower tax rates would stimulate economic activity 
to such an extent that the impact on the budget would be neutral- 
ized. The deficit could then be reduced by cutting government

spending. But the decision to increase defense expenditures at 
the same time as taxes were cut made a balanced budget unattain- 
able. The interaction between a swelling budget deficit and strict 
monetary targets sent interest rates sky high. High interest rates 
swamped the stimulative effect of the tax cuts. The budget deficit 
widened, and the economy plunged into a deep recession. 
The impact on the rest of the world was awesome. The debtor

countries were hit by a threefold increase in oil prices, plunging 
commodity prices, soaring interest rates, a strong dollar, and a 
worldwide recession. They engaged in a final binge of borrowing 
that increased their total debt outstanding another 30%, but the 
ratios measuring their creditworthiness rapidly deteriorated. The 
situations in Poland and in the Falklands helped to undermine 
confidence. There was a twilight period during which banks con-

tinued to lend, but reluctantly. Maturities were shortened, and 
some countries developed liquidity problems. Then the Mexican 
debt crisis erupted in 1982, and voluntary lending to the heavily 
indebted countries came to a virtual standstill. The position of

The International Debt Problem 99 
the debtors was much worse than most bankers had realized. For 
instance, Brazil was using the interbank market to finance its 
balance-of-payments deficit, unbeknownst to the correspondent 
banks. The international lending boom turned into a bust. 
We shall pause at this: point to analyze the international lending 
boom as a reflexive process in its own right. The above descrip- 
tion contains all the necessary ingredients of a boorntbust se-

quence. What are they? 'First, there must be a reflexive connection 
between the underlying trend and the participants' perception. 
Second, there must be a flaw in the participants' perception that 
influences the underlying trend through a reflexive connection. 
The trend reinfomes the bias until a point is reached where they 
both become unsustainable. Typically, the trend appears to be 
sound when it is first established and the flaws become apparent

only when the trend is already well advanced. There is a twilight 
period during which the participants grow increasingly leery and 
reluctant, and the trend loses momentum. Eventually, the reali- 
zation that the trend is unsound and unsustainable comes crash- 
ing in. The prophecy is self-fulfilling and the trend is reversed, 
often with catastrophic consequences. 
In the case of international lending, there are a number of re- 
flexive connections between the banks and the debtor countries.

Banks use debt ratios to measure a country's capacity to borrow. 
These ratios were generally considered to be objective measure- 
ments, whereas in fact they are reflexive. As we kve seen, both 
exports and GNP are influenced by the volume of international 
lending in a number of ways. Moreover, debt ratios measure only 
a debtor country's capacity to pay, not its willingness. To measure 
willingness a different calculation is needed vcrhich is essentially

political in character. The critical variable is not debt service but 
net resource transfer, that is, the difference between debt service 
and the inflow of new credit. As long as debtor countries can 
borrow freely their willingness to pay is not in doubt: they can 
always borrow the money they need to pay the interest. But as 
soon as the flow of credit is interrupted, the willingness to pay 
becomes the critical issue. Bankers refused to face the issue dur-

ing the great lending boom. Walter Wriston of Citicorp asserted 
that "sovereign nations don't go bankrupt. " 
As we have seen, debt ratios remained largely satisfactory until 
the second oil shock, and banks were eager to lend. When debt 
ratios finally began to deteriorate, the banks started to worry and

100 Historical Perspective 
their willingness to lend was impaired, precipitating the crisis of 
4 1982. The crisis brought the reflexive connection between net 
resource transfers and willingness to pay into play, leading to a 
permanent breakdown in voluntary lending. What happened af- 
terward will be the subject of the next chapter. Here we are con- 
cerned with analyzing the system that prevailed until 1982. 
Why the commercial banks were willing and able to sustain

such explosive growth in their international loan portfolios is a 
fascinating question that will be hotly debated for years to come. 
Part of the answer is that banks did not consider themselves re- 
sponsible for the soundness of the system. Banking is an intensely 
competitive business, whichis, however, subject to regulation. 
It is the job of the central banks to prevent excesses. Commer- 
4 cia1 banks operate under a protective umbrella; they seek to max-

imize their profits within the framework of existing regulations 
and they cannot afford to pay too much attention to the systemic 
effects of their activities. A commercial banker who refuses to go 
after what seems like profitable business is liable to be pushed to 
the side, and even if a bank decided to abstain there are many 
others anxious to take its place. Thus, even those who realized 
that the international lending boom was unsound found them-

selves obliged to participate or lose their places. 
There is an important lesson here: participants are not in a 
position to prevent a boom from developing even if they recog- 
nize that it is bound to lead to a bust. That is true of all boomhust 
sequences. Abstaining altogether is neither possible nor advis- 
able. For instance, in my analysis of mortgage trusts I clearly 
predicted a bad end, yet mv advice was to buy now because the

shares would have to rise substantially before they crashed. As it 
happened, a certain class of investors responded with alacrity. 
But even if they had not done so, the boomhust sequence would 
have occurred, albeit more slowly. 
The best that a participant can do is to cease to be a participant 
at the right time. But that may not always be possible. For in- 
stance, in a system of fluctuating exchange rates, holders of finan-

cial assets have an existential choice in deciding what currency 
to hold: they cannot avoid holding some currency, except by buy- 
ing options. In the case of international lending, Citicorp deliber- 
ately reduced its market share in the later stages of the boom; but 
that did not stop the drama from unfolding and Citicorp from 
being caught up in it. Toward the end most banks knew that the

The International Debt Problem 101 
position of the debtor countries was rapidly deteriorating, yet 
they could not disengaie themselves. 
The lesson to be learned is that financial markets need to be 
supervised. Only some, kind of intervention, be it legislative, reg- 
ulatory, or a gentle hipt from a central bank, can prevent boom/ 
bust sequences from getting out of hand. 
The history of centrtfl banking is a history of crises followed by

institutional reform. It is truly surprising that the lessons of the 
international debt crisis have still not been learned. The cham- 
pions of unregulated competition are more vocal, and more influ- 
ential, than ever. They base their case on the inefficiency of 
regulators and i$ must be admitted that they have a point. The 
participants could not have prevented the international lending 
boom from getting out of hand, but the monetary authorities could 
have. Why did they fail to do so?

have. Why did they fail to do so? 
There is no clear answer to this question. Central banks were 
aware of the explosive growth of the Eurodollar market, although 
they lacked reliable st,atistics. They recognized their responsibil- 
ities as lenders of last resort and mapped out their respective 
spheres of responsibility as early as 1975, but they did not deem 
it necessary to regulate the growth of Eurodollar lending. Why? 
The question requires more thorough historical research than it

has received so-far. I shall hazard two tentative hypotheses. 
One is $at the central banks themselves were influenced by the 
competitive pressures that affected the commercid banks under 
their aegis. Had they imposed regulatory restrictions, the banks 
under their supervision would have lost business to others. Only 
concerted action by all the central banks could have brought the 
burgeoning Eurodoiliw market under control. That would have

required institutional reform, and the monetary authorities did 
not recognize the need for reform. Refom usually occurs after a 
crisis, not before. 
That is where the second hypothesis comes into play. I contend 
that the central banks were acting under the influence of a false 
ideology. It was a time when monetarism was gaining ground 
among central bankers. Monetarism holds that inflation is a func- 
tion of money and not of credit. If monetarism is valid, the growth

of money supply needs to be regulated, not the growth of credit. 
Accordingly, there was no need to interfere with the Eurodollar 
market: as long as the central banks regulate their own money 
supply, the market will regulate itself.

102 Historical Perspective 
The issue is arcane and I cannot claim to understand it fully. ' Money shows up on one side of the balance sheet of banks and 
credit on the other. Milton Friedman tells us that it is the money 
side that counts because the other side is determined by the 
money side.2 The theory of reflexivity leads me to believe that his 
theory is wrong. I would expect that the two sides influence each 
other in a reflexive fashion, and his dream of controlling the

money supply is impractical. I lack sufficient expertise to take 
him on directly, but I can point to the empirical evidence that 
shows that the money supply always fails to behave in accor- 
dance with the regulators' wishes. 
\What role the growth of the Eurodollar market has played in 
the worldwide inflation of the 1970s has never been decided. For 
t that matter, we do not know the extent to which the contraction 
of international lending is responsible for the deflationary pres-

sures that seem to dominate the world economy at present. I 
firmly believe that both the expansion and the contraction of in- 
ternational lending have been important influences on the world 
economy, but my view is far from being generally accepted, and 
the issue remains unresolved to this day. If my view is correct, 
the volume of international credit ought to be an important con- 
sideration in setting economic policies. Monetary authorities

committed a serious error in allowing it to get out of hand during 
the late 1970s. The crisis of 1982 is as much a failure of regulation 
as a failure of the free market. 
We shall return to this issue again later. The imperfection of 
both regulated and free markets is one of the main themes of this 
book. Now we have to deal with the new system of international 
lending that evolved in response to the crisis of 1982.

--- -- 
THE COT.T.ECTIVE SYSTEM OF LENDING 
4 
There can be no doubt that without the active and imaginative 
intervention of the authorities the international debt crisis would 
have led to the collaise of the banking system, with disastrous 
consequences for the world economy. The last time such a col- 
lapse occurred was in' the 1930s. Because of that experience, an 
institutional framework was established with a mandate to pre-

vent a recurrence. Therefore it is inconceivable that events would 
have been allowed to unfold without intervention. It is the form 
that the intervention took that created a situation without parallel 
in history.' rr* 
The institutional setup gives central banks the authority, and 
obligation, to act as lenders of last resort. But the debt problem 
was too big to be handled by providing liquidity to the banks. The 
amounts involved far exceeded the banks' own capital; if &e

countries in question had been allowed to go into default, the 
banking system would have become insolvent. Accordingly, 
the central banks exceeded their traditional role and banded to- 
gether to bail out the debtor countries. 
A precedent of sorts had been established in England in 1974, 
when the Bank of England decided to bail out the so-called fringe 
banks that were outside its sphere of responsibility rather than to 
allow the clearing banks, from whom the fringe banks had bor-

rowed heavily, to come under suspicion. But the crisis of 1982 
was the first time that the strategy of bailing out the debtors was 
applied on an international scale. 
The central banks did not have sufficient authority to execute

104 Historical Perspective 
such a strategy, and makeshift arrangements had to be made in 
I which the governments of all the creditor countries participated 
and the IMF played a key role. A rescue package was put together 
for one country after another. Typically, commercial banks ex- 
tended their commitments, the international monetary institu- 
tions injected new cash, and the debtor countries agreed to 
austerity programs designed to improve their balance of pay-

ments. In most cases, the commercial banks also had to come up 
with additional cash enabling the debtor countries to stay current 
on their interest payments. The rescue packages constituted a 
remarkable achievement in international cooperation. The partic- 
ipants included*the International Monetary Fmd, the Esnk for 
International Settlements. a number of governments and central 
banks, and a much larger number of commercial banks. In the

case of Mexico, for instance, there were more than 500 commer- 
cial banks involved. I shall refer to the participants as "the Collec- 
tive." 
The process was repeated several times over a short period of 
gme. The story of what actually happened would make fascinat- 
ing reading, but here we must confine ourselves to examining the 
outcome. 
The system of lending that emerged from the crisis is in many 
ways the opposite of the system that broke down in 1982. The

prior system was competitive: banks were lending willingly, in 
pursuit of profit and in sharp competition with each other. The 
new system is cooperative: banks are lending under duress, in the 
hope of protecting their already committed assets, and they act 
jointly with other banks to this end. The prior system was reflex- 
ive in a positive direction: the banks' willingness and ability io 
lend were both reinforcing the debtor countries' ability and will-

ingness to pay, and vice versa. In the present situation, reflexivity 
works in the opposite direction: it is the banks' inability and 
unwillingness to lend and the debtor countries' inability and un- 
willingness to pay that are mutually self-reinforcing. The system 
could not survive without the various participants actively coop- 
erating to prevent a collapse. Action by the lenders takes the form 
of extending new credit in order to enable debtor countries to

service their existing debt; action by the borrowers consists of 
accepting austerity programs that keep the amount of new credit 
needed to a minimum. What that minimum is depends on deli- 
cate negotiations between lenders and borrowers. The IMF has 
taken the lead in conducting these negotiations, although debtor

The Collective System of Lending 105 
countries are generally reluctant to allow the IMF a permanent 
role in monitoring thelagreements. 
The system is highly precarious because it requires both lend- 
ers and borrowers to ,override their narrow self-interest for the 
sake of remaining paq of the system. In the case of debtors, the 
sacrifice is measured 6y negative resource transfers; in the case of 
the banks, by the amount of new credit extended. The sacrifice is

not symmetrical, however, because the borrowers pay interest on 
the newly extended credit, while the lenders receive it. Only if 
the banks forgave some of the interest or principal would they 
suffer an actual loss. But the Collective system of lending is based 
on the principle that the integrity 3f !hm debt must be preserved 
-that is the principle that holds the Collective together. Unfor- 
tunately, it leaves a crucial problem unresolved: debtor countries

need concessions to service their debt, but each concession adds 
to their future obligations. Recognizing the problem, banks are 
building bad debt reqerves; but no way has been found to pass 
these reserves on to tfie debtor countries without destroying the 
principle that holds the Collective together. 
The Collective system of lending came into existence un- 
planned and unannobnced. It has been transitional from its in- 
ception and it is bound to lead to something else. The most

interesting question that can be asked about it is what its eventual 
outcome will be. Unfortunately, this is not a question that can be 
satisfactorily answered. For one thing, reflexive messes do not 
have a predeteryined outcome: the outcome is determined in the 
course of the process. For another, the prediction itself can influ- 
ence the outcome. In this case, the hope that the Collectives will 
accomplish their mission is one of the main forces holding them

together; any statement that has a bearing on that hope immedi- 
ately becomes a part of the situation to which it refers, so that it 
is impossible to keep the discussion objective. Nevertheless, the 
question is pressing. Can the approach I have taken help to pro- 
vide an answer? And can an answer help to develop a theory of 
reflexivity? 
I published two papers1-one in July 1983 and one in March 
1984-in which I tried to analyze the international debt problem

using a theory of reflexivity but not spelling it out. This is what I 
said (with minor modifications): 
For heavily indebted countries, the collapse of voluntary lending 
has forced a drastic readjustment. The readjustment can be divided

106 Historical Perspective 
into four phases. In the first phase, imports decline; in the second, 
4 exports increase. During the first two phases, domestic economic 
activity slows. In the third, domestic economic activity recovers 
and both imports and exports rise. In the fourth phase, the advance 
in GDP and exports exceeds the increase in debt service require- 
ments and the adjustment is complete. 
The first phase is involuntary. When the flow of credit is cut off,

the trade deficit is automatically eliminated by a cut in imports. 
Living standards are reduced, the production process may be dis- 
rupted, and the country is plunged into depression. The amount of 
lending required of the Collective is determined by the inability of 
the debtor country quickly to generate a trade surplus sufficient to 
cover debt service requirements. 
It is in the second phase that the real adjustment begins. The

currency is devalued in real terms, and productive resources, idled 
by the reduction in domestic demand, are reoriented toward ex- 
ports. The trade balance improves, and the ability to service the 
debt improves with it. 
It is at this point that the willingness to pay and the willingness 
to lend become crucial. The country in question must increase its 
imports in order to support a domestic recovery. That means a 
reduction in the amount available for negative resource transfer. If

the hurdle is passed, the third phase begins. Domestic recovery 
renders negative resource transfer more palatable. As the economy 
expands, the creditworthiness of the country begins to improve, 
provided that exports grow faster than the GDP. When that hap- 
pens, the adjustment process has been accomplished. 
On the lending side, Collectives operate with a chronic shortage 
of resources. Commercial banks can be divided into two categories:

those whose very survival is at stake and those who are only mar- 
ginally involved. The first category co~stitutes the sore cif ;El Col- 
lectives. They can be counted upon Po participate, but their 
capacity to do so is limited. Marginal members need more persua- 
sion. As the sense of urgency diminishes, the marginals wish to 
withdraw, leaving only majors to provide the flow of fresh credit. 
The categories are flexible. The large U.S., U.K., and Japanese

banks will always remain core members; U.S. regionals and many 
continental banks are marginal to start with. In between the two 
groups there are many banks whose existence is at stake today but 
who may be able to build up sufficient reserves over a period of 
time to qualify as marginal in the future. 
Because of the actual or potential shrinkage of membership, the 
resources of the Collectives are liable to remain fully stretched.

The Collective System of Lending 107 
out the injection of additional funds from international lending 
institutions, but the institutions also are fully stretched. Thus, the 
Collectives are bound to push for the maximum resource transfers, 
making the hurdle between Phase 2 and Phase 3 difficult to pass. 
I concluded that the'collective system of lending "is a system 
born of emergency. It needs emergency conditions to survive, and

it is so constructed as 'to generate the emergency conditions that 
are needed to keep it in existence." 
By and large, this analytical framework stood the test of time, 
although in retrospect+ I did make two serious mistakes. First, I 
argued that dsbtcr csuzttries were willing to tolerate negative re- 
source transfers for two reasons: (1) to maintain access to capital 
markets and (2) to avoid seizure of assets. I neglected to consider

what turned out to be the most important reason: (3) to maintain 
access to export markets. With domestic markets in shambles, the 
threat that export markets might be closed off was a potent one. 
Argentina was relatively the best situated to overcome an em- 
bargo because most of 'its exports were fungible commodities, but 
even Argentina sells many items, such as shoes and steel, that are 
destined for specific markets. Moreover, the newly elected Argen-

tine government did not want to be isolated from the Western 
world. It was determihed to avoid an "economic Falklands." As a 
result, the threat of default never became as serious as I expected. 
In my analysis I did not put much store in the &st two induce- 
ments. As regards free access to capital markets, I maintained that 
the system of lending that prevailed prior to 1982 had broken 
down for good~It had been based on certain misconceptions

which had been recognized es such. The pasitive bias had been 
replaced by a negative one, and it would take a long time to 
overcome it. Events have borne out this analysis: bank lending to 
less developed countries is far below projections. As regards the 
seizure of assets, I dismissed it as a more or less empty threat. 
Since then this point of view has been fully doc~mented.~ Having 
ignored the third and most potent inducement, I concluded that

"the only way to ensure that the debtor countries will honor their 
debt is to make credit available in quantities that approximate 
their debt service obligations." 
This conclusion was false. In 1984 less than half the interest 
had to be advanced in the form of new credit, and much of the 
new credit came from sources other than the commercial banks.

108 Historical Perspective 
As a result, the cash drain on commercial banks was less severe ' than I had envisioned, and the strain between core members and 
marginal members never reached the breaking point. In fact, even 
core members have been able to begin building reserves against 
bad debts and improving their capital ratios. 
The second mistake I made was to underestimate the ability of 
debtor countries to increase exports. The world economy turned

out to be much stronger than I expected, for reasons that will be 
discussed in the next chapter. Brazil, in particular, produced a 
much larger trade surplus than I had expected. The official target 
for 1984 was $9 billion; the actual figure exceeded $12 billion. 
The strength in exporb led "i a modest domestic recovery and 
enabled Brazil to enter Phase 3. 
t These two mistakes together were sufficient to render my anal- 
ysis unduly pessimistic. In February 1984 I asserted that "it is

increasingly unlikely that much progress can be made in Phase 3, 
and Phase 4 appears increasingly unattainable under the present 
system." Yet by 1985 several of the major debtors had entered 
Phase 3, and the worst seemed to be over. Then came the precip- 
itous drop in oil prices in 1986, and Mexico became a casualty. 
The emergency could be attributed to external causes, but recent 
developments in Brazil are much more ominous. As a result of

the Cruzado Plan the economy became overheated in no time and 
the international trade balance deteriorated dangerously. As soon 
as the government was reelected in a landslide victory, it started 
to rein in the economy. Even so, it is clear that domestic political 
considerations take precedence over international debt obliga- 
tions, and 1987 is likely to be a year of crisis in Brazilian debt 
negotiations. 
Positions have softened considerably on the part of the creditor

countries. U.S. Treasury Secretary James Baker recognized the 
need for domestic growth in the debtor countries in the plan he 
launched at the Seoul meeting of the World Bank in October 1985. 
Subsequently, the Bradley Plan expressly advocated forgiving a 
portion of the interest and principal on the accumulated debt. 
The fact is that the trade surpluses of the debtor countries have 
become troublesome for the United States. The banks are better

reserved than they were a few years ago, so that 1987 may well 
bring some measure of protection coupled with some measure of 
loan forgiveness. If the experience of the last five years is any 
guide, the changes will not be radical enough to cause a break- 
down of the system.

The ColIective System of Lending 109 
Although it was faulty in its details, my analytical framework 
remains valid in its broad outlines. It is not a blueprint for suc- 
cessful adjustment but rather a model for surviving failure. As we 
have seen, the Collective system is held together only by the 
threat of a breakdown.,As we shall see, this is a characteristic of 
many arrangements wgich have prevailed since 1982.

REAGm'S IMPERIAL CIRCLE * 
At the time of the international debt crisis I was working with a 
rather crude and inarticulate model of credit expansion and credit 
contraction similar to a boom/bust sequence in the stockmarket. I 
thought that 1982 was the end of a period of worldwide credit 
expansion and failed to anticipate the emergence of the United 
States as the "borrower of the last resort." 
The large and growing U.S. budget deficit emerged as the unin-

tended consequence of conflicting policy objectives. On the one 
hand, President Reagan sought to reduce the role of the federal 
government in the economy by reducing taxes; on the other, he 
wanted to assume a strong military posture in confronting what 
he considered the Communist menace. These two objectives 
could not be pursued within the constraints of a balanced budget. 
To make matters worse, fiscal and monetary policies were dom-

inated by two conflicting schools of thought. Fiscal policy was 
influenced by "supply-side" economics, whereas monetary pol- 
icy was guided by the precepts of monetarism. 
The supply-siders believed that a tax cut would have such a 
stimulating effect both on output and on willingness to pay taxes 
that the economy could grow at a rapid rate without exacerbating 
inflation and the budget would be brought back into balance by

higher tax receipts. It was a thoroughly reflexive line of reasoning, 
and it contained serious flaws, as such reasoning usually does. Its 
* This chapter, finished in August 1985, has not been updated. Developments 
since then are dealt with in the real-time experiment (Part 111).

Reagan's Imperial Circle 111 
validity hinged on its be,ing universally accepted; therefore, it was 
an all or none proposition. In a democracy that functions by com- 
promise, such propositions rarely prevail. In this case, the 
chances of success were particularly poor because there was an- 
other major school of t+ught influencing government policy. 
Monetarists believed that the primary objective was to bring 
inflation under control ~nd to that end the money supply must be

strictly regulated. Instead of controlling short-term interest rates, 
as it had done hitherto, the Federal Reserve fixed targets for 
money supply and allowed the rate on federal funds to fluctuate 
freely. The Federal Reserve's new policy was introduced in Oc- 
tober 1979, and interest rates were already at record levels when 
President Reagan took office. In his first budget, he cut taxes and 
increased military spending simultaneously. Although a con-

certed effort was made to reduce domestic spending, the savings 
were not large enough to offset the other two items. The path of 
least resistance led to a ,large budget deficit. 
Since the budget deficit had to be financed within the limits of 
strict money supply targets, interest rates rose to unprecedented 
heights. Instead of economic expansion, the conflict between fis- 
cal and monetary policy brought on a severe recession. Unexpect-

edly high interest rates combined with a recession to precipitate 
the international debt 'crisis of 1982. Henry Kaufman had long 
warned that government deficits would drive other borrowers out 
of the market.' He proved to be right but it was theforeign gov- 
ernments that were driven out first, not the domestic users of 
credit. 
The Federal Reserve responded to the Mexican crisis of August 
1982 by relaxing its grip on the money supply. The budget &licit

was just beginning to accelerate. With the brakes released, the 
economy took df and the recovery was as vigorous as the reces- 
sion had been severe. It was aided by a spending spree by both 
the private and the corporate sectors and it was abetted by the 
banking system. Military spending was just gearing up; the pri- 
vate sector enjoyed rising real incomes; the corporate sector ben- 
efited from accelerated depreciation and other tax concessions.

Banks were eager to lend because practically any new lending 
had the effect of improving the quality of their loan portfolios. 
The demand emanating from all these sources was so strong 
that interest rates, after an initial decline, stabilized at historically 
high levels and eventually began to rise again. Banks bid for de-

112 Historical Perspective 
* posits aggressively and holders of financial assets could obtain 
even higher returns from the banks that from holding government 
obligations. Foreign capital was attracted, partly by the high re- 
turn on financial assets and partly by the confidence inspired by 
President Reagan. The dollar strengthened and a strengthening 
currency combined with a positive interest rate differential made 
the move into the dollar irresistible. The strong dollar attracted

imports, which helped to satisfy excess demand and to keep 
down the price level. A self-reinforcing process was set into mo- 
tion in which a strong economy, a strong currency, a large budget 
deficit, and a large trade deficit mutually reinforced each other to 
produce noninflationary growth. 1 have called this circular rela- 
tionship Reagan's Imperial Circle because it finances a strong mil- 
I itary posture by attracting both goods and capital from abroad.

This makes the circle benign at the center and vicious at the 
periphery. 
It can be seen that the Imperial Circle was built on an internal 
contradiction between monetarism and supply-side economics. 
The outcome was not intended or even anticipated. Many mo- - mentous historical developments occur without the participants 
fully realizing what is happening. The tremendous transfer of 
resources to less developed countries that occurred between 1974

and 1982 could not have taken place in a planned and organized 
manner, and, as we have seen, the Collective system of lending 
came into existence unintended and unannounced. 
Most professional economists did not consider the emergence 
or the survival of a benign circle possible, but President Reagan, 
despite his intellectual limitations, seems to have had a better 
understanding of what was possible than did his economic advis-

ers. After all, the reflexive process of the Imperial Circle fitted 
well with his concept of leadership-which is, of course, a reflex- 
ive concept par excellence. He was therefore content to pay lip 
service to the desirability of balancing the budget, ignored and 
eventually got rid of Martin Feldstein, and left the deficit well 
enough alone. Europeans complained about the strong dollar- 
although it is not quite clear why-but the U.S. administration

insisted on a policy of benign neglect. 
A benign circle for the United States is a vicious circle for the 
debtor nations. The trade deficit of the United States is mirrored 
by trade surpluses in other countries. To the extent that a strong 
export performance has enabled heavily indebted countries to

Reagan's Imperial Circle 113 
become current on their interest payments, the effect may be 
judged beneficial; but, even here, the benefit accrues to the lend- 
ers. For the rest, the debtor nations have been laboring under high 
real interest rates and very unfavorable terms of trade. Dollars are 
cheap when they are boyowed, but expensive when the interest 
has to be paid. The scramble to export depresses the prices of the 
commodities exported. qlthough the external performance of the

debtor countries has exceeded most expectations, the internal 
performance is much less satisfactory. There are some that have 
shown practically no recovery, and even among the more success- 
ful ones per capita income has been lagging; now that it has begun 
to rise the trade surplus1 is beginning to deteriorate. Somr: of tht? 
weakest countries have endured a downward spiral in which both 
their domestic economies and their abilities to service their debts

have deteriorated to the vanishing point. This group comprises a 
large part of Africa and some Latin American and Caribbean 
countries like Peru and the Dominican Republic. 
As far as the more dgveloped countries are concerned, rising 
exports to the United States have had a stimulating effect but the 
response has been very subdued. Corporations have been reluc- 
tant to add to capacity because they are afraid, and justifiably so,

that the dollar will decline just when their capacity comes on 
stream. By contrast, holding financial assets in dollars exerts an 
almost irresistible attraction. The phenomenon is particularly no- 
ticeable in Britain, where currency swings have becpn especially 
wild. The whole of Europe has been languishing with high un- 
employment and little growth, and it has become fashionable to 
speak of "Eurosclerosis." The Far East has shown much greater

dynamism under the impetus of the newly industrialized cmrr- 
tries and the opening up of China. Japan has been the greatest 
beneficiary of the present state of affairs. Its position is almost the 
mirror image of that of the United States, with a large export 
surplus and strongdomestic savings counterbalanced by the ex- 
port of capital. 
Let us try to analyze Reagan's Imperial Circle with the help of 
the analytical tools we have developed so far. We shall use the

notation adopted in Chapter 3. The four key elements are a strong 
economy ( t v), a strong currency ( t e), a growing budget deficit 
( 3. B), and a growing trade deficit ( 3. 7'). At first sight, there are 
some obvious contradictions between these four variables. Con- 
ventional economics tells us that a growing trade deficit ( 3. T)

114 Historical Perspective 
tends to depress both the exchange rate ( J. e) and the level of 
domestic activity ( J. v): 
But the Imperial Circle managed to overcome these causal rela- 
tionships with the help of two other variables: the budget deficit 
and capital inflows. 
The economy strengthened because the stimulus of the budget 
deficit outweighed the drag of the trade deficit. Economic activity 
is, of course, influenced by many other factors. To bring them all

into the picture would complicate the argument unduly. What 
matters is the end result: a strong economy. To keep the picture 
simple, we shall denote the net effect of all other factors with a 
question mark (?), giving us the formula 
Similarly, the dollar appreciated because capital inflows- 
J. (N + S)-exceeded the trade deficit: 
These two relationships are the mainstays of the Imperial Circle. 
There are many other relationships at work, so many that it

would be onerous to list them all. Some reinforce the Imperial 
Circle; others work against it; yet others reinforce it in the short 
run but cannot be sustained in the long run. The most important 
self-reinforcing connection is between the exchange rate and 
speculative capital inflows: 
We have already identified two connections that work against the 
Imperial Circle (Equation I), and here we can mention two con- 
nections that are self-reinforcing in the short run, but unsustain-

able in the long run. First, while speculative capital inflows are

Reagan's Imperial Circle 115 
self-reinforcing in the short run, they also generate interest and 
repayment obligations that are cumulative and work in the oppo- 
site direction. 
Eventually the growing debt service ( N) is bound to undermine 
the relationship on which the Imperial Circle rests and the trend 
of the exchange rate is going to be reversed: 
At that time, debt service and the flight of speculative capital may 
combine with the trade' deficit to generate a catastrophic collapse

of the dollar: central bank officials, Volcker foremost among them, 
are aware of the danger and are publicly warning against it.2 To 
put matters in perspective, it should be pointed out that it would 
take many years for interest charges to accumulate to a point 
where they would reverse the balance. The likelihood is that the 
Imperial Circle will be reversed or at least brought to a halt long 
before that. Volcker and other responsible government officials

are certainly working %o\vard &at end. 
The crucial question confronting the world is whether the Im- 
perial Circle can be arrested without precipitating a catastrophic 
collapse of the dollar. The longer it lasts, and the higher the dollar 
climbs, the greater the danger of a fall. The problem is that a clear- 
cut reversal in the trend of the dollar could, even at this stage, 
cause a shift not oqy in the ongoing flow of investment but also

in the accumulated stock of speculative capital. The stock is, of 
course, many times larger than the ongoing flow. The problem is 
widely recognized, making the holders of dollar assets very ner- 
vous. That is why foreign holdings of marketable assets are aptly 
described as "hot money." 
The second example is the budget deficit, which is stimulative +.

116 Historical Perspective 
in the short run but may be counterproductive in the long run 
I because it diverts resources from more productive uses through 
the interest rate mechanism: 
4 As long as high interest rates suck in capital from abroad, the 
problem remains latent. With the help of foreign savings, the do- 
mestic economy can consume more than it produces. Only when 
the capital inflow ceases to match the budget deficit does the

problem become acute. Interest rates must rise in order to generate 
the domestic savings necessary to finance the budget deficit. The 
consequent decline in consumption depresses the economy, mak- 
ing foreigners all the less willing to hold dollar assets. This may 
give rise to a "disaster scenario" in which a weak economy and a 
large budget deficit combine to produce high interest rates and a 
weak dollar. 
We can combine these relationships to create an integrated

Reagan's Imperial Circle 117 
In this model, one of the mainstays of the Imperial Circle, Equa- 
tion 2, is shown horizontally and the other, Equation 3, vertically. 
It will be seen that the model is not stable: some connections 
reinforce it while others undermine it. The factors best reinforced 
are the speculative inflows and the trade deficit; the factor most 
endangered is the level 'of economic activity. The main threats to

the stability of the Imperial Circle come from the trade deficit and 
the budget deficit. The thin pillars of the arrangement are a strong 
dollar and a strong economy; but a strong dollar leads to a rising 
trade deficit that weakens the economy and the budget deficit 
keeps interest rates higher than they would be otherwise, which 
also weakens the ecacorny, These are the internal inconsistencies 
that are likely to destroy the Imperial Circle long before the accu-

mulation of debt service obligations would do so. 
N dless to say, the model is incomplete. There are many con- 
necTns that are not 'shown; the illustration is complicated 
enough as it is. Perhaps some connection that has been ignored 
here will come to the rescue of the Imperial Circle when the need 
arises. We have already witnessed such occasions. For instance, 
until the middle of 1984, banks were active in expanding credit 
at home and attracting funds from abroad. When they stopped

functioning as the main conduit, for reasons that will be ex- 
plained in Chapter 8, the Treasury took their place: the withhold- 
ing tax was abolished, and a large portion of the government debt 
was sold directly to foreigners. 4 
It would be interesting to construct a more complete model and 
endow the variables with numerical values. I believe it would be 
possible to simulate the evolution of the U.S. economy since 
1982, but I am not equipped to carry out wch an operation. I have

to confine myself to an impressionistic presentation. 
We are dealing with a system that is not stable, but constantly 
evolving. What will succeed the Imperial Circle? That is the ques- 
tion that needs to be answered. Before I attempt to do so, let me 
complete the picture by taking a closer look at the banking system 
and the corporate restructuring that is currently sweeping the 
country. i

8 
EVOLUTION OF THE BANKING SYSTEM 
It is generally recognized that the international debt crisis of 1982 
constituted a dramatic point for the debtor countries. The direc- 
tion of resource transfers was reversed and the magnitude of the 
swing was limited only by the debtor countries' capacities to pay. 
In our model of the Imperial Circle the swing shows up as a 
nonspeculative inflow ( N) because it is guided by considera- 
tions other than total return. The amounts involved are signifi-

cant: net resource transfers to heavily indebted countries swing 
from $50.1 billion in 1982 to a reverse flow of $13.8 billion in 
1983,' most of it in dollar form. Resource transfers from the heav- 
ily indebted countries have provided one of the major underpin- 
nings for the Imperial Circle. 
It is less well recognized that the crisis of 1982 did not bring a 
similar turning point for the banking system. The largest banks 
were too deeply involved to allow them to reverse direction. Had

they stopped lending altogether, the heavily indebted countries 
would have had to default. Had they tried to set up adequate 
reserves, their capital position would have been impaired. It was 
to preserve these banks that the Collectives were established. We 
have dealt with the role of the Collectives in tiding over the debtor 
countries; now we must examine what happened to the banking 
system. 
The Collective system of lending operates on the principle of

voluntary cooperation. The regulatory authorities had to exert 
themselves to make it possible for the heavily involved banks to 
extend new loans and to induce less involved banks to cooperate.

Evolution of the Banking System 119 
The only way they could achieve these objectives was by main- 
taining the fiction tha't the outstanding loans were unimpaired 
and no special reserves had to be set up against them. There was 
some divergence of opinion among the various supervisory agen- 
cies but the Federal Reserve, as lender of last resort, maintained 
the upper hand. The banking system was considered too weak to 
be given any strong medicine. Accounting standards were modi-

fied and special effortd were made to enable banks to meet them. 
The last-minute bridge loan to Argentina on March 1, 1984, 
stands out as the most dramatic intervention by the Federal Re- 
serve. 
Eurcpean central banks took e different tesk. They encowaged 
commercial banks to set up reserves and write down bad loans. 
They could afford to do so. European banks were, on the whole, 
less deeply involved, and their accounting system permitted the

accumulation of large hidden reserves. The United Kingdom oc- 
cupied a halfway position between the Continent and the United 
States. Some British banks were amongst those with the highest 
loan exposure to less developed countries, but they had a much 
sounder deposit base%in their own branch system so that they 
were never as susceptible to a crisis of confidence as their Amer- 
ican counterparts. 
It may be argued that the Federal Reserve went too far in sup-

porting the money center banks. These banks were allowed to 
treat as current income the rescheduling fees anbxceptionally 
wide spreads they charged on paper but did not collect in cash. 
As a result, they could report substantial earnings gains, and some 
of them actually increased their dividends in 1983. 
Ironically, the formation of the Collectives, and the permissilre 
attitude of the regulatory authorities that accompanied it, delayed

and diverted the adjustment process in the U.S. banking industry. 
Debtor countries had to face harsh reality, but banks were left 
with a large load of doubtful debt whose doubtful quality they 
had to hide. The ~nly way they could collect the interest was by 
making additional loans. Thus the problem was not only unac- 
knowledged but also growing, The banks responded by trying 
to grow even fast&. The most desirable way to grow was to pro-

vide services without tying up assets. Money center banks devel- 
oped a host of new services and marketed them aggressively. 
But they were not averse to expanding their balance sheets, 
either. Almost any loan was of better quality than their portfolio

120 Historical Perspective 
of loans to the less developed countries. This was the heyday of 
leveraged buyouts; banks were willing to grant very generous 
terms. Banks were also aggressive bidders for deposits abroad 
and used the funds to build up their domestic asset base. Thus 
they became the primary vehicle for attracting capital to the 
United States. 
Unfortunately, banks were unable to use their remarkably good 
reported earnings to raise equity capital, because the stock market

saw through the charade and bank shares were valued at substan- 
tial discounts from stated asset values. Chemical Bank managed 
to seize a propitious moment and sell some shares; Manufacturers 
Hansver alss placed shares in connection wi4& its acquisition ui 
CIT Corp.-but these were exceptions. On the whole, banks had 
I to rely on retained earnings, which could not keep pace with the 
growth in assets. 
Nevertheless, there was a race to expand and diversify. Manu-

facturers Hanover acquired CIT Corp. at a hefty price and the 
artifice of the "nonbank bank" was invented in order to circum- 
vent existing restrictions on geographical diversification. The 
money center banks were pressing for permission to expand 
across state lines, but they ran into stiff opposition from regional 
banks who wanted protection. The protracted battle has only re- 
cently been resolved, giving the regional banks a breathing space

before the money center banks are allowed to buy up banks out- 
side state limits. 
The Federal Reserve did not wish to put any constraints on the 
banking system that would have a negative effect on the economy. 
The first priority was to prevent a collapse and to that end they 
wanted to engineer a strong recovery. Only when the recovery 
was well under way did they rein in the money supply, allowing 
interest rates to rise. They could have also tried to rein in the

banks, but that is not what happened. Bad loans continued to 
accumulate and capital ratios continued to deteriorate. Confi- 
dence in the banking system remained precarious. 
Eventually troubles surfaced in the domestic loan portfolios. 
Large segments of the economy, notably agriculture and the oil 
industry, did not participate in the recovery. In contrast to the 
international debt, it was impractical to keep the domestic bor-

rowers afloat by lending them the money to pay the interest be- 
cause there were just too many of them. Continental Illinois Bank 
was particularly badly hit because it had followed loose lending

Evolution of the Banking System 121 
practices. Specifically, it had purchased a large amount of un- 
sound energy loans from Penn Square Bank, which had gone 
bankrupt. Having no branches, it was in the unfortunate position 
of being heavily dependent on borrowed funds. Thus it became 
the focal point of concern. 
There was also troubte brewing in the savings and loan indus- 
try. The equity of many institutions had been wiped out by the

rise in interest rates pridr to 1982. To prevent wholesale collapse, 
a large number of institutions had to be merged or otherwise sal- 
vaged during 1982. The Reagan administration was looking to the 
market mechanism for a solution. In one of the most remarkable 
episodes in financial history many of the mgnlatory constraints 
were removed just at a time when the capital of the industry 
was seriously impaired. The range of activities in which savings

and loan companies could engage and the range of assets they 
could invest in were greatly extended. Since the savings and 
loans had gotten into trouble in a regulated environment it 
was assumed that the, removal of constraints would help to 
get them out of trouble. Private enterprise did in fact devise 
ingenious ways to salvage bankrupt savings and loan com- 
panies. Most of the new money invested was immediately re- 
couped as a tax loss and sawy investors gained control of

institutions licensed to gather government-insured deposits 
with very little cash investment. Some of these institutions 
fell into the hands of operators who could use su& deposits in 
support of other activities from which they profited. They had 
much to gain but little to lose from expanding aggressively. 
This was a formula for disaster. It is surprising that it was not 
recognized as such. 
The company that exploited the opportunity presented by the

regulators most aggressively was Financial Corporation of Amer- 
ica under the dynamic leadership of its president, Charles Knapp. 
Having acquired First Charter Financial, an old established insti- 
tution whose deposits were insured by the Federal Savings and 
Loan Insurance Corporation (FSLIC), it went on a borrowing 
spree, using brokgrs as well as a high-powered in-house sales 
force. It then invested heavily in rather risky real estate loans as

well as fixed-rate mbrtgages. If any of the loans went sour, another 
developer was found who would take it over in exchange for a 
much larger loan on his own development. As interest rates began 
to rise, the company averaged up its fixed-rate mortgage portfolio

122 Historical Perspective 
at an exponential rate. Knapp figured that in this way he would 
have a high-yielding portfolio when interest rates finally declined 
and if he grew large enough he could not be allowed to go broke 
even if interest rates did not decline: heads he would win, tails 
he could not lose. The calculation was correct. The company grew 
from $4.9 billion in deposits in 1982 to $20.3 billion in 1984. As 
the financial position of the company deteriorated, Knapp was

forced out (after receiving severance pay in seven figures) but the 
company was resc~ed.~ 
The crisis in Continental Illinois Corp. and Financial Corpora- 
tion of America came to a head more or less concurrently in the 
=mmer of 1984. That was the true turning point fw Liul'king 
and thrift industries, although this fact is still not properly appre- 
I ciated. Bank examiners remembered their statutory duty and 
began to take a stand on bad loans. Regulators tightened capital

requirements, and insisted on strengthening bad debt reserves. 
Banks responded by shrinking their balance sheets, selling off 
assets, and packaging loans for resale rather than putting them on 
the books. The period of unsound growth came to an end and the 
adjustment process finally began. 
At first blush, the adjustment has been remarkably smooth. 
Banks became adept at packaging loans for resale, developing a 
variety of financial instruments ranging from floating rate notes to

mortgage pass-through certificates. Whenever necessary, other in- 
stitutions have taken over the banks' role. Junk bonds have re- 
placed bank loans in financing mergermania, and Treasury bonds 
have taken the place of Eurodollar deposits in sucking in capital 
from abroad. It is no coincidence that the withholding tax on 
foreign-owned bonds was removed just as the turning point in 
bank expansion was reached. 
With every passing quarter, the financial position of the banks

ought to improve. Individual banks may be hurt when they have 
to recognize losses but the industry as a whole ought to become 
sounder. The stock market responded positively to the changed 
outlook: bank shares rose to levels where they were selling at 
premiums over book value. 
But the period of danger is not yet over. It is after a trend has 
been reversed that the full effect of the preceding excesses is felt. 
While banks were given leeway, they could cover up their bad

loans by extending additional credit. But when banks are required 
to set up reserves against bad or doubtful loans it does not pay

Evolution of the Banking System 123 
them to throw good money after bad. On the contrary, they have 
every reason to liquidate bad loans, because by doing so they can 
convert non-earning assets into earning assets and they may also 
be able to recapture some of the reserves they have been obliged 
to set up. The danger is that the liquidation of bad loans uncovers 
other bad loans. For instance, there were many farmers who could

not service their debt but the value of their land was still high 
enough to provide adequate collateral: these farmers were given 
additional credit rather than forced into bankruptcy. But the liq- 
uidation of bankrupt farmers is depressing land prices, so that 
additional farmers are forced into bankruptcy. The same is hap- 
pening in the oil industry, and at the time of this writing (Septem- 
ber 1985) ominous signs are emerging in real estate. shipping is 
probably next in line.

probably next in line. 
The bankruptcy of Community Savings Bank of Maryland and 
its subsidiary, Equity Programs, Inc. (EPIC), in 1985 serves as a 
paradigm of what happens when the trend is reversed. The insti- 
tution in question had been acquired by real estate developers 
who carried on their syndicating activities as a subsidiary of the 
thrift institution. They specialized in financing model homes and 
enjoyed a good reputation. The mortgages on these homes were

insured by private mortgage insurance companies and sold to 
investors in the form of mortgage-backed securities. Following a 
run on state-insured savings banks in Ohio, savings banks in 
Maryland were required to seek federal insurance. The Federal 
Savings and Loan Insurance Corporation, in its chdened mood, 
insisted that the real estate syndicating subsidiary should be 
sold before the parent was granted FSLIC cover. That caused the

whole situation to unravel. The subsidiary coiild not syndicate 
any new loans, and without new syndicaiions it could not ser- 
vice its outstanding mortgages. It turned out that the income 
from the already syndicated homes had been insufficient to cover 
the mortgages and the deficiency had been habitually made up 
from new syndications. In theory, the model homes would even- 
tually be sold and would start to produce income, but, in practice,

the subsidiary had become heavily indebted to the parent and 
it appears that some of the model homes did not even exist. The 
subsidiary had issued about $1.4 billion of mortgage-backed se- 
curities and the ,moFgage insurance companies were on the hook. 
The potential liability exceeded the assets of some of the insur- 
ance companies in question, and if they cannot meet their obli-

124 Historical Perspective 
gations the security of mortgage-backed securities may be , endangered. * 
My brief account of recent events is sufficient to show that 
regulators are not exempt from bias. They are participants in a 
reflexive process and operate on the basis of imperfect under- 
standing, just like those whom they regulate. On balance the reg- 
ulators understand the business they supervise less well than 
those who engage in it. The more complex and innovative that

business is, the less likely that the supervisory authority can do a 
competent job. 
Regulation always lags behind events. By the time regulators 
have caught up with excesses, the corrective action they insist on. 
tends to exacerbate the situation in the opposite direction. That is 
what has happened in the period under study. By the time the 
4 authorities discovered that international lending was unsound it 
was too late to correct the situation because the correction would

have precipitated a collapse. When they finally insisted that 
banks recognize their losses, their insistence reinforced the col- 
lapse of collateral values in areas such as agriculture, the oil in- 
dustry, and shipping. 
Commercial bankers have also committed many mistakes, but 
at least they have an excuse: they operate within guidelines laid 
down by the regulators. Their job is to compete, not to worry 
about the soundness of the system. Their excuse is valid in the

sense that, as long as there is no fraud involved, the authorities 
will, in fact, bail them out if they get into difficulties. This com- 
pounds the responsibility that regulators have to shoulder. 
The authorities have given a good account of themselves when- 
ever the situation has deteriorated to the crisis point. To sane 
extent, this is due to the merit of the individuals involved. Events 
might have taken a different course if it had not been Volcker who

was in charge of the Federal Reserve. He displayed a positive 
eagerness in confronting difficult situations and coming up with 
innovative solutions that is rare in a bureaucrat. But there is also 
an institutional reason. Central banks are given a mandate to act 
as lenders of last resort. They have incomparably more authority 
in an emergency than in the ordinary course of events. They are 
* Subsequently, one of the mortgage insurance companies, Ticor Mortgage In-

surance Company, went out of business, but the mortgage-backed securities 
market was not endangered.

Evolution of the Banking System 125 
geared to crisis management and quite incompetent when it 
comes to problem solvihg. To achieve any lasting solutions, the 
whole machinery of the administration and Congress needs to be 
involved. That means that needed reforms are rarely enacted in 
time. 
The banking crisis of '1984 has left us with an unresolved di- 
lemma. There is a basic imbalance in deregulating deposit-taking 
institutions and guaranteeing depositors against loss. The guar-

antee enables financial institutions to attract additional deposits 
at will, and deregulation gives them wide latitude in putting those 
deposits to use. The combination of the two is an invitation to 
unrestrained credit expansi-on The problem has been inherent in 
the system of Federal deposit insurance since its inception but at 
the time the FDIC was founded banks were strictly regulated. The 
imbalance between risk and reward became more pronounced as

the trend toward deregulation gained momentum, and it reached 
a critical point in the crisis of 1984. 
The Federal Reserve was forced to expand its role as lender of 
last resort and guaranteb all depositors against loss whatever the 
size of their deposits. This removed the last vestige of the disci- 
pline that depositors are supposed to impose on banks. In the 
absence of that discipline there is nothing left but the regulatory

authorities to stop financial institutions from engaging in un- 
sound lending practices. 
It may be argued that shareholders would act as asonstraining 
influence because they remain at risk, but the constraint is not 
very effective since a bank can cover up its losses by lending even 
more. By the time the losses can no longer be hidden, much more 
will have been lost than the equity capital. Thus, hil~ring equity 
and loan capital at risk is not sufficient to ensure sound lending

practices. 
The regulatory authorities have, in fact, become much stricter 
since 1984. Yet the popular and political bias in favor of deregu- 
lation is as strong as ever. The geographic and functional restric- 
tions imposed in the Great Depression are in the process of being 
dismantled. Theoretically, there need be no conflict between de- 
regulation and stricter supervision; but in practice there is. As we 
have seen, regulators make mistakes; the more varied and change-

able the business, the less likely that it will be adequately super- 
vised. There is a strong prima facie case for keeping the deposit- 
taking business as simple as possible. On the other hand, simple,

126 Historical Perspective 
regulated businesses tend to breed stodgy, conservative manage- 
ments. It boils down to a choice between stability and innovation. 
When one of these ingredients is missing its absence is sorely felt. 
As a consequence, preferences tend to swing from one extreme to 
another. At present we are still elated by the opportunities that 
have been opened up by the removal of outdated regulations; but 
the need for stability is increasingly pressing.

the need for stability is increasingly pressing. 
There is another simmering problem that is approaching boil- 
ing point. It concerns the treatment of insolvent financial institu- 
tions. Traditionally, the authorities prefer to arrange the 
acquisition of failing institutions by larger, sounder ones. Such 
forced mergers used to offer an easy way out when the industry 
was tightly regulated, failures were few and far between, and the

4 acquiring institutions were financially strong. The failing bank 
had a valuable franchise that could be auctioned off to the highest 
bidder without endangering the structure of the industry. But as 
the process of credit expansion and deregulation progressed, the 
procedure of "merging out" insolvent units became both more 
frequent and less satisfactory. The franchises became less valu- 
able and the acquiring institutions less able to withstand a dilu-

tion of their financial strength. A concentrated industry is 
seemingly stronger. For instance, the clearing banks of the United 
Kingdom have never had any difficulty in attracting deposits, al- 
though Midland Bank, for one, was in worse shape than any of 
the surviving banks in the United States. But increasing concen- 
tration increases the danger of catastrophic losses. What would 
happen to the United Kingdom if the clearing banks were unable

to collect the interest on their loans to less developed countries? 
Closer to home, Bank cf America was encouraged to acquire First 
of Seattle; but who is going to acquire Bank of America if the need 
arises? * We have already had the first instance, that of Continen- 
tal Illinois Bank, where no buyer could be found. We may yet 
arrive at a point where several of our largest banks end up as 
public property. It has happened in other countries.

In no instance was the idea of merging out sick units so ill 
conceived as in the savings and loan industry. As we have seen, 
* To my great surprise, as of December 1986, First Interstate is avidly pursuing 
BankAmerica, Chemical Bank is buying Texas Commerce Bank, and 
RepublicBank is willing to take over one of the weakest banks in Texas, Inter- 
first, in order to prevent out-of-state competitors from gaining a foothold in the 
state.

Evolution of the Banking System 127 
much of the industry became insolvent during the 1980-82 pe- 
riod of record high interest rates. The authorities devised the bril- 
liant scheme of selling off ailing units to adventurous 
entrepreneurs who appreciated the privilege of being able to at- 
tract federally issued aeposits. We have seen how entrepreneurs 
like Charles W. Knapp of the Financial Corporation of America 
exploited the privilege. Now that the regulators have put a stop to

uncontrolled expansibn, many of the excesses are beginning to 
surface. Only the decline in interest rates has saved us from an 
avalanche of insolvencies.

THE: "OLIGOPO~ATION" OF 
AMERICA * 
Within the context of Reagan's Imperial Circle there is another 
important reflexive development under way: the corporate struc- 
ture of the United States is being reshaped by means of mergers, 
acquisitions, divestitures, and leveraged buyouts. The move has 
the dramatic quality usually associated with reflexive processes 
and it has reached proportions that endow it with historical sig- 
nificance. Its roots go back to well before the inception of the

Imperial Circle but it has .gained tremendous momentum since 
1982. The process of corporate restructuring is clearly interrelated 
with the Imperial Circle but so far the relationship is rather lop- 
sided: prevailing economic and political conditions provide the 
context in which the restructuring occurs but the evolution of the 
Imperial Circle has not been significantly affected by corporate 
restructuring. The process that can be loosely described as mer-

germania is therefore best regarded as a sideshow rather than an 
essential ingredient of the Imperial Circle. 
In its impact on the corporate structure of the United States, 
mergermania has already exceeded the conglomerate boom. Con- 
glomerates started out as relatively small companies that became 
large through acquisitions; mergermania has involved the largest 
entities in corporate America. There are many similarities be- 
tween the two developments but the differences are more pro-

* This chapter has been kept as it was originally written in June 1985, with a 
brief postscript added in December 1986.

The "Oligopolarization" of America 129 
nounced. If the conglomerate boom represents the simplest case 
of an initially self-reinforcing and eventually self-defeating pro- 
cess, mergermania is perhaps the most complex. The conglomer- 
ates provided a paradigm of boom and bust; mergermania 
exemplifies a reflexive process in which the self-reinforcing and 
self-defeating interactiohs are not sequential but simultaneous. 
I shall not attempt a descriptive history of mergermania. I shall

simply assume that the, reader is more or less familiar with the 
discrete corporate events that have occurred in the last few years. 
My own familiarity with mergermania is not much greater than 
that of a well-informed, member of the public because I did not 
participate in it in a professional capacity. 
Corporate events have been occurring continuously ever since 
there have been organized stock markets. Whenever the market 
value of the shares is higher than the value of a company as a

privately owned entity1 the corporate event consists of a sale of 
shares; whenever the market value is lower, a purchase of shares 
is involved. The purchaser may be the company itself, the man- 
agement, an outside group, or another company that may have a 
special reason for putting a high value on the shares. 
The conglomerate boom combined the buying and selling of 
shares. Conglomerates were selling their own shares at inflated

prices and buying the shares of other companies. They could put 
a higher value on the shares of other companies than the market 
because the acquisitions helped to support the ov~rvaluation of 
their own shares. Thus the conglomerate boom was essentially a 
phenomenon of overvaluation with inflated securities serving as 
the means of exchange. 
By contrast, in the current process of corporate restructuring 
the primary means of exchange is cash. The cash may be bor-

rowed in a number of ways, but the final result is the same: shares 
are bought for cash. There are occasional mergers that are accom- 
plished by an exchange of shares but they are not characteristic of 
the trend. There are also many developments, notably the dispo- 
sition of assets and operating divisions, that do not involve the 
purchase or sale of shares at all; yet the event that characterizes 
the current process and qualifies it as a reflexive one is the pur-

chase of shares for cash. Thus mergermania is predicated on the 
undervaluation of shares: the company as a whole must be worth 
substantially more than the market capitalization of its shares. 
The undervaluation started to develop after the second oil

130 Historical Perspective 
shock when a concerted effort was made to bring inflation under 
t control through stringent monetary policy. It was greatly rein- 
forced after Reagan became president and the Imperial Circle 
evolved. 
We can discern three factors in the relative undervaluation of 
shares: economic, political, and tax related. The first two are def- 
initely interconnected with Reagan's Imperial Circle; the third is

due to the peculiarity of our tax system. I shall emphasize it be- 
cause it provides that element of distortion that seems to be an 
essential ingredient in reflexive processes. 
As long as interest expense is tax deductible, it pays to acquire 
companies with borrowed cash, became there is a savicg on taxss. 
That is one of the major motivations in leveraged buyouts. There 
I are many other, more arcane, tax benefits involved, but this is not 
the place to explore them.*

the place to explore them.* 
Shares traditionally have been valued as a multiple of earnings. 
When the rate of interest is high, the multiple tends to be low. 
But earnings are only a part of pretax cash flow, often a minor 
part. Yet, it is cash flow that is the primary criterion in determin- 
ing the value of a business as a candidate for acquisition. Thus 
the traditional method of valuing shares has helped to create op- 
portunities for acquisition, especially in periods, such as the Im-

perial Circle, when earnings are depressed and interest rates 
relatively high. 
Let us take a profitable but mature company with little scope 
for expansion-a so-called cash cow. If it is acquired with bor- 
rowed funds, the interest can be paid out of pretax earnings. To 
the extent that the market discounts pretax earnings at a rate 
higher khan the prevailing interest rate, the is a margin of eai- 
ings, in addition to the free-cash flow, that can be used to pay

down the loan. Eventually, the acquirer is left with a debt-free 
company. As that point approaches he could, in theory, sell the 
shares to the public, realizing a capital gain. He could then turn 
around and buy back the shares from the public and start the 
process all over again. In practice, several of the early leveraged 
buyouts have resurfaced as new issues. I do not know of any 
* Several of them, notably the so-called General Utilities doctrine, which allows

the acquiring company to write up assets and depreciate them from a higher 
base, have been eliminated in the Tax Reform Act of 1986. The tax deductibility 
of interest has not been changed, but the corporate tax rate has been lowered 
from 48% to 34%, thereby reducing the tax benefit of using borrowed money.

The "Oligopolarization" of America 131 
instances where a refloated company has gone private again, but I 
know of cases where previous leveraged buyouts have been relev- 
eraged in private transactions. 
It can be seen that the tax system has made cash cows particu- 
larly susceptible to leveraged buyouts, while the Imperial Circle 
has had the unintended consequence of turning companies into 
cash cows. The mechhism by which the effect is achieved is high

real interest rates and an overvalued currency. High real interest 
rates render financial assets more attractive, and physical invest- 
ments less attractive; thus they provide an incentive not to put 
cash to work in expanding the business but rather to use it as a 
financial asset: buying in shares or acquiring other companies. An 
overvalued currency tends to render industrial activity less prof- 
itable: export markets shrink and domestic markets come under 
price pressure from irqports.

price pressure from irqports. 
The combination of high real interest rates and an overvalued 
currency proved to be a potent brew. The producers of tradable 
goods have been put under great strain; often their survival is at 
stake. They have reacted by consolidating: shedding unprofitable 
divisions, abandoning activities where their market position is 
weak, and concentrating on those areas where their position is 
worth defending. Traditional attitudes have been shaken up;

often there has been a change in management. Gone are the days 
when corporations pursued growth for its own sake; free cash 
flow and profits have assumed an importance VmPiich they had 
previously enjoyed only in textbooks. Managements have started 
to look at their businesses more like an investment fund manager 
looks at his portfolio. This has created a suitable atmosphere for 
corporate restructuring. 
Every time an acquisition occurs, it tends to narrow the gap

between market prices and the value to the acquirer. This brings 
us to the most curious feature of the process. One would expect 
that the acquisitions of shares for cash would reduce the extent of 
undervaluation to a point where acquisitions are no longer prof- 
itable and the movement comes to a stop. Why has the gap not 
been closed? To answer this question, we must invoke a political 
factor. The Reagan administration believes in the magic of the

marketplace. This finds expression, first of all, in the deregulation 
of regulated industries, but it also permeates the government's 
attitude toward corporate activity in general. 
There has been no formal reform of antitrust laws but there has

132 Historical Perspective 
I been a radical shift in what is considered an antitrust violation. 
Market share is no longer viewed in a static but in a dynamic 
context. Competition need not be preserved within a given indus- 
try because companies can compete with each other across indus- 
try lines. Bottles compete with cans, plastic competes with glass, 
aluminum with steel. Technological advances can open up ave- 
nues of competition that did not exist previously. Long-distance

telephone service is the best example: what had been considered 
a natural monopoly has become a highly competitive market. 
Moreover, the U.S. market is no longer viewed in isolation: inter- 
national competition protects the interests of the consumer, es- 
pecially when the dollar is so strong, and the national interest 
+ dictates the consolidation of *U.S. producers into fewer and 
stronger units. Whether these considerations will remain as valid

in the future as they seem at present is open to question; but, 
while they prevail, large-scale combinations do not face the polit- 
ical obstacles they would have encountered in previous adminis- 
trations. I call the process the "oligopolarization~' of America. 
Under the Carter administration any large-scale acquisition, 
like the purchase of Utah International by General Electric, pro- 
voked an antitrust investigation that slowed down the transaction

even if it did not abort it. It was generally believed that companies 
above a certain size were both immune from attack and disquali- 
fied from making significant corporate moves. They lived in a sort 
of suspended animation with managements safely ensconced and , 
confined to operating their existing businesses. Since this view 
was rarely challenged, it was not corroborated by evidence but 
prevailed in the form of a bias. Th bias found expressinn in stack

valuations. Smaller companies were perceived as having greater 
exposure to corporate activity and in consequence tended to be 
more highly priced. Between 1974 and 1979 the shares of small 
companies outperformed large ones by a considerable margin, 
and investors specializing in small capitalization stocks enjoyed 
a field day. Corporate activity, such as leveraged buyouts, was in 
fact concentrated in that sector. 
After 1980 there was a gradual but perceptible shift. The size of

deals increased and industries once considered immune became 
susceptible to attack. For instance, a few years ago beleaguered 
companies used to acquire radio or TV stations as a way of de- 
fending themselves; now the industry is up for grabs. Both ABC 
and RCA (which owns NBC) were taken over in friendly deals 
and CBS, under attack, gained a new controlling shareholder.

The "Oligopolarization" of America 133 
The trend was not qecognized at first, but as it spread from 
industry to industry it captured the imagination of investors and 
it is now fully reflected in share valuations. Since 1980, relative 
performance has shifted back in favor of large capitalization 
stocks, and mergermaqia has undoubtedly played a part in the 
move. As the process continues, a point will be reached when 
expectations exceed re+lity and the stock prices of the candidates

will hamper the conclusion of deals. The spread between pre-deal 
prices and the pdees actually paid has already narrowed but the 
pace of transactions has not yet slackened. Mergermania has gen- 
erated a momentum of its own and undoubtedly there will be 
'some deals concluded 'at unreasonable prices before the process 
exhausts itself. 
Looking at mergermania analytically, we may classify the re- 
flexive interaction as primarily self-defeating or self-correcting. If

there is a self-reinforcing connection, it is lateral rather than ver- 
tical: it expands the number and size of companies affected rather 
than raising stock valses to unsustainable heights. There is rela- 
tively little vertical or price action. Successful acquirers, such as 
GAF Corp., attain higher stock prices and, if they can successfully 
recapitalize themselves, they can swallow another company. If 
the process lasts long% enough, favorites will emerge with pre-

mium valuations that will make it easier for them to fulfill expec- 
tations. Mesa Petroleum was in the process of emerging as such a 
premium company until Unocal stopped it in its..tlfacks. On the 
other hand, Esmark has gone full circle, first acquiring and then 
being acquired. 
The self-reinforcing connection comes at first from the elimi- 
nation of a negative bias. What has been done with one company 
can be done with another and, encouraged by success, people

attempt what had not been thought possible before. Eventually 
excesses are bound to develop. In order to get a better insight we 
must take a closer look at the players. First, there are the merger 
and acquisition departments that engineer the corporate transac- 
tions; then there are the lawyers who dream up new attacks and 
new defenses; the actual acquirers; the providers of credit; and 
the arbitrage traders who hold the stocks before and during deals

and often become active participants; finally, there are the regu- 
lators who are supposed to supervise the process. All the partici- 
pants, with the exception of the regulators, stand to earn very 
large profits from successful transactions. 
Excessive profits often lead to other excesses, especially when

134 Historical Perspective 
I credit is involved. There is not much point in listing them in a 
general way. Each transaction is high drama and drama is con- 
structed out of human foibles. A narrative of specific events 
would recount many mistakes, exaggerations, abuses, as well as 
some bold maneuvers and brilliant inventions. In this respect, 
mergermania does not differ from other activities that generate 
windfall profits. There is a general predilection to pursue such

activities until some failures exert a discouraging effect. When 
credit is used on a large scale, failures can mdwball. We have 
already had at least one occasion when a large arbitrage trader, 
Ivan Boesky, was forced to liquidate his positions, forcing some 
others to do iikewise. There has also been much concern about 
the debt accumulated in leveraged buyouts. Until recently most 
I of the credit came from banks. As we have seen, they were trying

to grow their way out of their difficulties after the international 
debt crisis, and leveraged buyouts provided a ready market. But 
the regulatory authorities started to discourage bank lending for 
leveraged buyouts even before the twin crises of the Continental 
Illinois Bank and the Financial Corporation of America. For a 
time it looked like financing would dry up, and the pace of cor- 
porate activity did slow down. That was in the second half of

1984 just after some large oil companies had been gobbled up; the 
elections were approaching and it was felt that additional take- 
overs might be politically embarrassing. Mergermania resumed 
with renewed vigor after the elections but the main source of 
financing shifted from banks to junk bonds. The shift was proba- ' 
bly dictated by necessity-Unocal sued Security Pacific Bank for 
providing credit to a corporate enemy-but it turned out t~ be a

technical improvement. Junk bonds are more flexible and more 
easily arranged; they also offer some wrinkles that can be ex- 
ploited for tax purposes. Drexel Burnham, the dominant force in 
junk bond financing, can provide almost unlimited funds at short 
notice. 
Will it all come to a bad end? That is impossible to predict. As 
we have seen, the main reflexive connection is a self-correcting 
one. The boomhust model we have developed for conglomerates

is not applicable. It is quite likely that the process will burn itself 
out after it has swept all the ground that is susceptible to it. But a 
disaster cannot be ruled out. The net effect is to introduce a great 
deal of debt into the restructured companies. A number of differ- 
ent scenarios could lead to situations where the debt is difficult

The "Oligopolarization" of America 135 
to service. If the Impe~ial Circle is reversed and the dollar falls 
just as the economy slips into recession, interest rates may also 
rise at the same time and highly leveraged companies would con- 
front the worst of all ,possible worlds. In the more immediate 
future, a precipitous f?ll in oil prices could endanger the cash 
flow of heavily indebted oil companies like Phillips Petroleum. 
One major default mi@ unravel the magic circle of junk bond

holders. 
Up till now, mergermania has not had a detectable influence on 
the fate of the Imperial Circle. It has probably reduced physical 
investment activity in the United States by making managements 
more oriented isward 'the short term, but investment remained 
surprisingly strong until recently. Mergermania has probably con- 
tributed to credit demands and induced banks to borrow abroad 
in order to lend at home; but when the role of the banks dimin-

ished, the influx of capital from abroad continued. If there is a 
reflexive connection, it* is too subtle to be readily discerned: it has 
to do with the generaliattraction the United States holds for for- 
eign capital at the present time. 
Another, more ominous, connection is beginning to surface. A 
great deal of credit is employed in the acquisition of companies; 
the credit is then repaid by disposing of the assets that served as

collateral. Both activities, the nonproductive use of credit and the 
sale of collateral assets, aggravate the prevailing deflationary 
trends. Mergermania may thus hasten the unwinding of the Im- 
perial Circle. 
Assuming that the process does not end in disaster, what is its 
overall effect? We find a mixed bag. In contrast to the conglomer- 
ate boom where most of the activity was confined to the stock- 
market, many changes will have occurred in the real world. On

balance, the profitability of corporations will be enhanced, assets 
redeployed, and stodgy managements shaken up. Industiies will 
have become more oligopolistic. As long as the Imperial Circle 
prevails these changes are desirable and probably necessary for 
the survival of many industries. If and when the competition from 
imports abates, the changes may turn out to be just the opposite 
of what is appropriate to the new conditions.* Accepting merger-

* P.S., February 1987: The stock market has begun to reflect the excess profits 
expected from the "oligopolarization" of America after price competition from 
abroad has abated.

136 Historical Perspective 
mania as a process of adjustment, we encounter a problem that is 
t inherent in a world of reflexive interactions: adjustment to what? 
It is like shooting at a target when the act of shooting moves the 
target. 
Even if corporate restructuring qualified as an adjustment pro- 
cess, it would benefit from being slowed down. If the pace were 
slower, fewer deals would be made because the rate of return 
would become less favorable. That would be an improvement

because there is a tendency to make more deals than are justified 
by long-term economic considerations. The tax laws are primarily 
responsible, but the participants playing with other people's 
msuey must ahso share part of the blame. England has a takeover 
panel that reviews the rules of the game; we could benefit from a 
I similar arrangement. 
On the level of theory, this analysis shows that the boom/bust 
model is not directly applicable to all reflexive processes. With

this lesson in mind, we shall now address the question: what will 
be the eventual outcome of the Imperial Circle? 
P.S., DECEMBER 1986 
As it happened, mergermania outlasted the Imperial Circle. Junk 
bonds suffered a few nasty moments when oil dropped below $10 
and LTV Corp. defaulted, but the market recovered. Both the eq- 
uity and the junk bond holders of leveraged buyouts have been 
greatly helped by the decline in interest rates, although junk

bonds have lagged behind high-quality bonds. The Tax Reform 
Act of 1986 has had the perverse effect of accelerating the pace of 
transactions prior to its taking effect on January 1, 1987. 
Then came the Boesky affair and the arbitrage community was 
shaken to its core. The full extent of the scandal is not yet known 
but can be easily imagined. The investigation has already immo- 
bilized many of the major players, and it is going to change the

way the game is played. By and large, the speculative excesses 
generated by mergermania will be removed; what will be left is 
the continuing restructuring of American corporations. The net 
inflow of cash into junk bonds will be reversed and the extent to 
which buyouts can be leveraged will be greatly reduced. Most 
important, it will become more difficult to refinance deals when 
they turn sour, and the junk aspect of junk bonds will become 
more apparent.

The "Oligopolarization" of America 137 
In short, the Boesky affair constitutes not the end of corporate 
restructuring but rather a well-defined and highly dramatic turn- 
ing point in the reflexive aspect of mergermania. As in other sim- 
ilar instances, it will be some time after the turning point when 
the casualties surface. The EPICS of mergermania are yet to come. 
(EPIC was the subsidiary that pushed the Community Savings 
Bank of Maryland into bankruptcy.)

THE STARTING POINT: AUGUST 1985 
We shall take up the history of the Imperial Circle at around the 
elections of 1984. Until then, the Imperial Circle had operated 
without a hitch with both the U.S. economy and the U.S. dollar 
continuing to rise. The central bankers of the world were fully 
aware that the situation was unsound and ultimately unsustaina- 
ble, and there was an episode at the beginning of 1984 when they 
tried to talk down the dollar but the attempt failed and the dollar

rose higher than ever. The economy continued so strong that it 
overcame even a modest rise in interest rates. Forei ners holding & dollar-denominated financial assets were really r 'ng it in. So 
were those exporting to the United States. Surprisingly, American 
industry hung in there in the face of severe pressure from imports, 
reluctant to transfer manufacturing abroad and trying to stay com- 
petitive by investing in high technology. The critical point was

reached around the final quarter of 1984. The pace of the economy 
was beginning to slacken and interest rates started to ease but the 
dollar, after an initial dip, continued to rally. Prevailing opinion 
had linked the strength of the dollar to the strength of the econ- 
omy and to the interest rate differential. When the dollar refused 
to weaken, the last of the trend fighters gave up and the exchange 
rate went through the roof. That was the straw that broke the

camel's back: American industry started in earnest to switch to 
imports and to foreign-based manufacturing. The strong dollar 
finally became an American problem. 
The conduct of U.S. economic policy underwent a significant 
change after the elections. Treasury Secretary Donald Regan and 
141

142 The Real-Time Experiment 
I presidential adviser James Baker switched places. Until then, the 
Federal Reserve and the Treasury had been at loggerheads, but 
now an understanding was reached between them. Slowing down 
the Imperial Circle became the clear-cut objective. It was to be 
achieved by reducing the budget deficit and relaxing monetary 
policy. America's main trading partners were encouraged to give 
their policy the opposite twist, engaging in fiscal stimulation but

keeping up interest rates. It was hoped that under these influences 
the dollar would finally decline. Treasury Secretary Baker went 
so far as to express willingness to discuss a reform of the exchange 
rate system prior to the Bonn economic summit in May 1985, but 
he failed to follow through. He was also unsuccessfuI in ga'ining 
control of the budget-cutting process in Congress; nevertheless, 
t the administration is clearly determined to accept whatever form

Congress chooses for cutting the budget. 
The dollar did respond with a thump, falling by about 15% 
against the German mark. Then it stabilized for about three 
months, and recently it started declining again. The adjustment 
so far is unlikely to bring any significant relief to industry. The 
economy is now divided into two segments: the tradable goods 
sector is in recession with the capital goods sector particularly 
weak, but the service and defense sectors are still strong. Interest

rates have fallen significantly and that is stimulating the econ- 
omy, but as long as the dollar remains anywhere near its present 
level, much of the stimulation will find its way abroad through 
increased imports. Most important, the pressure on profits in the 
tradable goods sector is unlikely to relent. 
What is the outlook? We can draw up two scenarios. In the first 
the dollar declines by, say, 20-25% bringing relief to the tradable

goods sector. Inflation may pick up a little, although the rise in 
import prices may be compensated for by a decline in oil prices, 
but the economy recovers, putting a floor under the dollar. This 
is the so-called soft landing scenario. Its prospects are better than 
at any time since the inception of the Imperial Circle because 
the authorities have finally recognized the need to bring the self- 
reinforcing process under control and are cooperating to that end.

It is conceivable that the ever more violent swings in exchange 
rates will moderate as-unannounced and unrecognized as usual 
-we pass from a system of free floating to a system of managed 
floating. 
The other possibility is that the dollar refuses to decline and, 
when it finally breaks, it does so precipitously. At first, foreign

The Starting Point: August 1985 143 
exporters absorb whatever small decline occurs and do not raise 
their selling prices in the face of a weakening market. The tradable 
goods sector continues under pressure, and the weakness threat- 
ens to spread to the other sectors. The Federal Reserve, deter- 
mined not to allow the economy to slip into recession because of 
the dire consequences it would have on the banking system, con- 
tinues to pump money into the economy but much of the stimu-

lation continues to leak out in the form of imports. Eventually, a 
critical point is reached when foreigners become reluctant to hold 
dollars, long-term interest rates rise in the face of rising money 
supply numbers, the ddllar declines precipitously, and inflation 
prospects deteriorate even as the ecouomy enkm+nb a full 
fledged recession. 
This may be called the disaster scenario, because a recession 
would expose an exceedingly fragile financial structure to a test

that it is unlikely to withstand without severe damage. The heav- 
ily indebted countries have barely entered into Phase 3 of their 
adjustment process. A ;weakening in demand for their exports 
could push them back into Phase 2 and the setback may be more 
than they can bear. At home, the adjustment process is even less 
advanced. A recession kould reduce the earnings capacity of bor- 
rowers; it would also undermine the resale value of the assets that

serve as collateral. As banks try to liquidate foreclosed property 
they set into motion a self-reinforcing process: other borrowers 
are pushed over the brink. The process is alreadysrnder way in 
the oil patch and in farming; in a recession it would spread to 
other sectors of the economy. 
This is where we stand at present (August 1985). As a market 
participant, I must make some decisions based on my evaluation 
of the probable course of events. The theory of reflexivity, as it

has been developed so far, does not yield any clear-cut predic- 
tions, but it can be helpful in formulating my views. I have used 
it in that capacity before and I shall attempt to do so now. 
I propose an experiment. I shall record the views that guide me 
in my investment decisions at the present time and I shall revise 
them on a real-time basis while the book is in preparation. I shall 
terminate the experiment when the book goes to the printer and

the reader will be able to judge the results. This will provide a 
practical test of the value, if any, of my approach. It will also 
provide an insight into the decision-making process of one market 
participant. 
A few words of explanation are needed about the investment

144 The Real-Time Experiment 
, fund I manage.* Quantum Fund is a unique instrument: it uses 
leverage; it operates in many markets; and, most important, I man- 
age it as if it were my own money-which it is to a large extent. 
Many funds share one of these features, but I do not know of any 
other that combines them all. 
The best way to understand the role of leverage is to think of an 
ordinary investment portfolio as something flat and loose, as its

name implies. Leverage adds a third dimension: credit. What was 
a loosely held together, flat portfolio becomes a tightly knit three- 
dimensional structure in which the equity base has to support the 
credit used. 
Leveraged funds usually employ their borrowed capital in the 
same way as their equity base. That is not the case in Quantum 
I Fund. We operate in many markets, and we generally invest our 
equity in stocks and use our leverage to speculate in commodities.

Commodities in this context include stock index futures as well 
as bonds and currencies. Stocks are generally much less liquid 
than commodities. By investing less than our entire equity capital 
in relatively illiquid stocks, we avoid the danger of a catastrophic 
collapse in case of a margin call. 
In managing the Fund, I distinguish between macroeconomic 
and microeconomic investment concepts. The former usually dic- 
tate our exposure in the various commodity markets, including

the stock market, while the latter find expression in our stock 
selection. Thus the ownership of a specific stock has both a macro 
and a micro aspect in the sense that it affects the total size of the 
Fund's stock market exposure, and, if it is a foreign stock, it also 
affects the Fund's currency exposure. By contrast, a stock index 
or currency position has only a macro aspect. We can, of course, 
always neutralize the macro aspect of a stock position through

stock indexes and currency futures. 
As far as currencies are concerned, I believe that a system of 
fluctuating exchange rates presents an existential choice: one can- 
not avoid having one's equity invested in some currency, and not 
making a decision about currency exposure is also a decision- 
unless, of course, one were to buy a currency option, in which 
case one would pay a measurable price for avoiding the choice. 
The logical consequence of my attitude is that I feel obliged to

make a decision about currencies even if I do not have a well- 
* Written in January 1987.

The Starting Point: August 1985 ' 145 
formulated macroeconomic investment concept. The results 
can be disastrous. Sometimes I envy my more ignorant fund- 
managing colleagues who do not know that they face an 
existential choice; for instance, they avoided the losses I in- 
curred in the 1981-198E period when the dollar continued to 
appreciate. 
It can be seen that Quantum Fund combines some of 
the features of a stock market fund with those of a commodity

fund. Historically, Quantum Fund operated at first almost exclu- 
sively in stocks; only as macroeconomic conditions became in- 
creasingly unstable did bonds and currencies assume increased 
importance. In the last few years macroeconomic speculation has 
become paramount. The degree of leverage we employ is much 
more modest than in pure commodity funds, and the exposure in 
various markets serves t~ balance as well as to leverage the port- 
folio.

folio. 
The Fund's maximum exposure in any direction is subject to 
self-imposed limits. If one relied on the limits imposed by margin 
regulations, one would be asking for trouble, because one would 
be forced to liquidate positions at the most inconvenient mo- 
ments. One needs a safety margin over and above the margin 
requirements. The safety margin can be quantified by looking at 
the uncommitted buying power, but it is not a reliable measure

because different types of investments carry widely divergent 
margin requirements. For instance, most U.S. stoas require a 
50% margin, foreign stocks only 30-35% and the margin on S&P 
futures is only 6%. Where to limit one's exposure is one of the 
most difficult questions in operating a leveraged fund, and there 
is no hard and fast answer. As a general rule, I try not to exceed 
100% of the Fund's equity capital in any one market, but I tend to

adjust my definition of what constitutes a market to suit my cur- 
rent thinking. For instance, I may add non-market-related stocks 
and market-related stocks together or keep them separate as the 
mood takes me. 
Generally speaking, I am more concerned with preserving the 
Fund's capital than its recent profits, so that I tend to become 
more liberal with self-imposed limits when my investment con-

cepts seem to be working. Where to draw the line between capital ' and profit is no easy task when practically the entire capital con- 
sists of accumulated profits. The historical record up to the begin- 
ning of the experiment is summarized below. It will be seen that

146 The Real-Time Experiment 
Quantum Fund N.V. 
Net Asset Value Change from 
Date Per "A" Share Preceding Year Size of Fund 
1/31/69 $ 41.25 - $ - 
12/31/69 53.37 + 29.4% 6,182,701 
12/31/70 62.71 + 17.5% 9,664,069 
12/31/71 75.45 + 20.3% 12,547,644 
12/31/72 107.26 +42.2% 20,181,332 
12/31/73 116.22 + 8.4% 15,290,922 
12/31/74 136.57 + 17.5% 18,018,835 
12/31/75 174.23 + 27.6% 24,156,284 
12/31/76 282.07 + 61.9% 43,885,267 . 
12/31/97 369.99 + 31.2% 61,652,385

12/31/97 369.99 + 31.2% 61,652,385 
12/31/78 573.94 + 55.1% 103,362,566 
12/31/79 912.90 +59.1% 178,503,226 
12/31/80 1,849.17 + 102.6% 381,257,160 
12/31/81 1,426.06 - 22.9% 193,323,019 
12/31/82 2,236.97 + 56.9% 302,854,274 
12/31/83 2,795.05 + 24.9% 385,532,688 
12/31/84 3,057.79 + 9.4% 448,998,187 
8/16/85 * 4,379.00 + 43.2% 647,000,000 
Unaudited. 
the only year prior to 1985 when the Fund more than doubled 
was 1980, and that was followed by a debacle in 1981.

During Phase 1 of the experiment, the Fund's activities re- 
volved mainly around macroeconomic issues; the microeconomic 
concepts did not change much, and their contribution to the 
fund's performance was relatively insignificant. Accordingly, in 
summarizing the Fund's investment posture I focused only on the 
macro aspect. The situation changed during the Control Period: 
specific investment concepts made an increasing contribution to

the Fund's performance. This was in accordance with my macro 
conclusion that it was time to play the stock market. Since the 
microplays became important only during the Control Period, I 
refrain from discussing them, with one exception: my play in 
Japanese real-estate-related stocks enters into the discussion in 
Phase 2. - 
The macro posture of the Fund is summarized in a table follow- 
ing each diary entry, and the activities and performance of the

Fund are shown graphically at the end of each phase of the exper- 
iment. The graphic presentation for the Control Period has been

The Starting Point: August 1985 147 
subdivided into two parts because it is roughly twice as long as 
the experimental phases:Thus, the graphs are broken down into 
four roughly equal time periods. 
NOTE: Here is the key fbr the parenthetical numbers (1) through 
(6) that appear in the diary-entry tables throughout the real-time 
experiment: I 
(1) Includes net dollar value of futures contracts. 
(2) Net purchases ( + ) or sales ( - ) since previous report.

(3) Reduced to a common denominator of 30-year government 
bonds. For instance, $100 million in face value of 4-year Trea- 
sury notes is equivalent to $28.5 million in market value of 
30-year government bonds. 
(4) U.S. Treasury bills and notes up to two years to maturity; 
these also have been reduced to a common denominator of 
30-year bond equividents (see note 3). 
(5) These bonds have cbnsiderably less volatility than U.S. gov-

ernment bonds. For instance, as of June 30, 1986, $100 mil- 
lion in face value of Japanese government bonds had the same 
volatility as roughly $66.2 million in 30-year U.S. government 
bonds. We have not,adjusted for this difference. 
(6) Net currency exposure includes stocks, bonds, futures, cash, 
and margins and equals the total equity of the Fsd. A short 
position in dollars indicates the amount by which exposure 
in the major currencies (DM-related European currencies,

yen, and sterling) exceeds the capital of the Fund. Exposure 
in other currencies (mast of which do not fluctuate as much 
as the major currencies) are shown separately. They are not 
deemed relevant in calculating the Fund's dollar exposure. 
Also, the percentage changes in net asset values in these tables 
refer to per-share figures. The figures for Quantum Fund's aggre- 
gate equity are affected, albeit modestly, by subscriptions and 
redemptions.

PHASE 1 : AUGUST 1985-DECEMBER 1985 
1 BEGINNING OF THE EXPERIMENT: SUNDAY, AUGUST 18, 
1985 * 
The stock market has recently adopted the thesis that the rapid 
rise in money supply is presaging a stronger economy. Cyclical 
stocks started to improve, while interest-rate-sensitive and de- 
fensive stocks suffered a setback. I had to decide what posture to 
adopt. I was inclined to doubt the thesis, but I did not have 
enough conviction to fight it. Accordingly, I did nothing. My

stock portfolio consists primarily of companies that stand to ben- 
efit from corporate restructuring and of property insurance shares 
that follow a cycle of their own. 
As regards currencies, I have been leaning toward a soft-landing 
scenario. In fact, I could envision the possibility that a stronger 
economy would tend to strengthen the dollar. With so many spec- 
ulators short, this could lead to a sharp, if temporary, rebound.

Thus, being short the dollar was not without risk. Accordingly, I 
had significantly reduced my currency positions. For reasons I 
shall outline below, I rebuilt them in the last few days. 
I have been inclined to be optimistic on the prospects of a soft 
landing because the decline of the dollar was induced by the 
authorities; a spontaneous fall would have been much more dan- 
gerous. Since the reelection of Reagan, the authorities have been

moving in the right direction and there seems to be a greater 
degree of cooperation among them. Practically all the excesses of 
* Charts showing the posture and performance of Quantum Fund in Phase 1 
follow p. 185. The key to the parenthetical note references (1) through (6) in the 
diary-entry tables can be found on p. 147.

Phase 1 : August 1985-December 1985 149 
, Aug. 16,1985 
Closing Closing 
811 6/85 811 6/85 
DM 2.7575 S&P 500 186.12 
% 236.75 U.S. T-Bonds 762Y32 
I E 1.4010 Eurodollar 91.91 
Gold 337.90 Crude Oil 28.03 
I Japanese Bonds - 
QUANTUM FUND EQUITY $647,000,000 
Net Asset Value Per Share $4,379 
Change from 12/31/84 + 43.2% 
I 
Portfolio Structure (in millions of dollars) 
Investment Net Currency 
Positions [I) Long Short, Exposure (6) Long Short 
Stocks DM-related 467

Stocks DM-related 467 
US Stocks 666 (62), Japanese Yen 244 
Foreign Pound Sterling 9 
Stocks 183 I US Dollar (73) 
Bonds (3) Other 
US Gvt. Currencies 50 
Short 
Term (4) (67) 
Long 
Term (46) 
Commodities sa Oil (121) 
Gold 
the Imperial Circle are in the process of being corrected: banks are 
returning to sounder practices, the budget deficit is being cut, and 
interest rates are being reduced. 
My optimism is tempered by the insight that the time when

past excesses are corrected is the period of greatest risk. The ex- 
cesses were meeting a certain need; otherwise they would not 
have developed in the first place. Can the system function with- 
out them? Moreover, the process of correction can develop its 
own momentum, setting off a self-reinforcing trend in the oppo- 
Everything hinges on the outlook of the economy. If the econ- 
omy strengthened in the second half of 1985, all would be well.

150 The Real-Time Experiment 
Even if there were renewed weakness in 1986, the financial struc- 
I ture would already be in a stronger position to withstand the 
consequences. In any case, that eventuality is too far removed to 
have any relevance to current investment decisions. 
I consider myself ill-qualified to match wits with professionals 
who have much more information at their disposal in predicting 
the actual course of the economy. That is why I have chosen to

stay on the sidelines in cyclical stocks. 
The single most important variable is consumer spending. 
Some experts claim that consumers are overextended; others 
argue that if you make money available, the American consumer 
can be counted on to spend it Who am 1 to judge? The only 
competitive edge I have is the theory of reflexivity. It leads me 
t to diverge from the consensus opinion on the negative side. I be- 
lieve we are in a period of credit contraction where collateral

values are eroding. It would be appropriate if consumers failed 
to respond to stimulation. This is a typical Keynesian situation 
where the horse is taken to the water: will it drink? I need more 
evidence before I can develop any conviction on the negative 
side. 
Recently, I have perceived such signals. Perhaps the most 
convincing was the market action itself. The stock market was 
acting suspiciously badly. It may be surprising that I should ac-

cept the stock market as a valid indicator after I had enunciated 
the principle that markets are always biased. But I have also 
claimed that the market has a way of making predictions come 
true. 
Various economic reports also indicated continued weakness. 
For instance, auto sales were do~vn. 3 did not aitrikte any great 
importance to these reports, because the current weakness is well 
recognized. What happens when General Motors starts its low

interest-rate promotion will be more significant. I was much more 
impressed with the report that this year's crops are going to set 
records. This meant that either the distress in the farming sector 
would increase or much more money would have to be spent on 
farm price support. 
The currencies were pushing against the upper limits of their 
trading range. The Bundesbank was expected to lower the dis- 
count rate, but the mark refused to give ground. On Wednesday,

August 14, I decided to establish a half position in the German 
mark; after the German discount rate was in fact lowered and the

Phase 1 : August 1985-December 1985 151 
mark remained firm, I bought the rest of my position. On Thurs- 
day afternoon, the Federal Reserve announced a large increase in 
MI; the increase in M3 was more moderate. Bonds fell and I 
recognized that my thesis on currencies was going to be tested. If 
the conventional wisdoin prevailed, currencies ought to fall in 
the expectation of a strhnger economy and higher interest rates. 
But if the tide has tuned, holders of dollar assets ought to re-

spond to a rise in money supply by converting part of that supply 
into foreign currencies. As it happened, the currencies did not 
yield, and my thesis was reinforced. 
Then came further evi,dence. On Friday, both housing starts and 
new permits were wee, especially for multifamily dwellings. 
This confirmed my suspicion that the housing industry is in trou- 
ble. In that case, commercial real estate must be in even worse 
shape. Bonds rallied, but the stock market continued under pres-

sure. 
I am now willing to bet that the slowdown in the economy is 
going to deteriorate into a recession: the contraction in credit is 
going to outweigh the increase in money supply. 1 suspect that 
the divergence between MI and M3 is an indication that the horse 
is not drinking. I am aeady to take on a maximum position in 
currencies, both on a long-term and on a short-term basis and to 
short bonds on the rally. If the currencies do not respond vigor-

ously, I may have to become more cautious and take a loss on the 
short-term portion of my currency positions. 
It may be asked why I should short bonds if I expes a recession. 
The answer is that I expect a recession because long-term interest 
rates will rise on account of a weakening dollar. This is the Im- 
perial Circle moving into reverse gear. I realize that my sale may 
be premature; consequently I will take only a small starting posi-

tion. I am also contemplating selling the stock market short but 
only if it rallies in response to a declining dollar. Both my cur- 
rency and my bond positions ought to work before I take on the 
additional exposure. 
The majority of my currency positions are in German marks. I 
also have a significant position in yen but I expect the yen to 
move slower and later. I should explain why. Japan has a very 
high savings rate and domestic investment has tapered off. By

investing its savings abroad, Japan is able to maintain a level of 
production well in excess of domestic consumption. This is the 
way Japan can become a leading economic power in the world:

152 The Real-Time Experiment 
a high savings rate, a persistent export surplus, and an accumu- 
1 lation of foreign assets go hand in hand to enhance Japan's 
power and influence in the world. Japan is very happy with the 
Imperial Circle and wants to prolong it as long as possible. The 
policy is articulated by Japanese officials as follows: "We want 
the United States to prosper as the leading economic power in 
the world, because it allows us to prosper as number two." In

actual fact, Japan uses the United States as a cyclist uses a car 
in front of him: to cut the wind resistance. Japan wants to stay be- 
hind the United States as long as possible, and it is willing to 
finance the U.S. budget deficit to this end. Long-term capital out- 
flows from Japan rose from $17.7 billion in 3,983 to $49.7 billion 
in 1984 and the trend is still rising. This has been the single 
t most important factor in keeping the yen down. Now that the

trend of the dollar has been reversed, the yen may appreciate 
against the dollar, but it is likely to fall against the European 
currencies. 
I have had considerable difficulty in arriving at this conclusion. 
In the 1970s, Japan followed a policy of keeping the value of the 
yen high, creating a high hurdle that exporters had to pass in 
order to export profitably. The policy was very successful in fa- 
voring the industries in which Japan had the greatest competitive

advantage and in discouraging the older, less profitable exports. 
I would have expected that in an environment where the rest 
of the world was increasingly unwilling to tolerate a Japanese 
export surplus, Japan would once again use the price mecha- 
nism to ration its exports rather than to expose itself to quanti- 
tative restrictions. This would have meant a high exchange rate 
policy. 
I failed to recognize the fundamental dissimilarity between the

two sets of circumstances. In the 1970s domestic investment 
was still very high and available savings needed to be rationed; 
a high exchange rate served as an efficient method of allocat- 
ing resources. Now there is an excess of savings for which 
outlets have to be found. Exporting capital is the best answer. 
The resistance to Japanese exports remains a stumbling block, 
but the Japanese hope to overcome it by providing generous

credit terms. Hence the willingness to finance the U.S. budget 
deficit. 
The American response is ambivalent. Some elements within 
the administration are pushing for a higher yen; others are push-

Phase 1: August 1985-December 1985 153 
ing for the sale of U.S. government securities to the Japanese. 
Ironically, it was American pressure for the liberalization of cap- 
ital markets that led to the current massive Japanese purchases of 
U.S. treasury bonds. The interest rate differential in favor of the 
U.S. was very great, ruhning as high as 6% at times. Once the 
floodgates were released, Japanese institutions piled in. Since the

dollar has started to decline, the total return has become less 
favorable, but it has not discouraged Japanese investors. On the 
contrary, they seem to feel that the currency risk is less now that 
the dollar has declined. Japanese investors are even more herdlike 
than their American coynterparts. Should their bias shift, there 
could be a stampede in ,the opposite direction. But that is highly 
unlikely: the authorities act as shepherds, and they will do what-

ever is necessary to prevent a stampede. If my analysis is correct, 
they are likely to keep the appreciation of the yen moderate 
enough to preserve the prevailing bias in favor of U.S. government 
bonds. 
I should also explain ply views on oil prices. A decline is more 
or less inevitable. Production capacity far exceeds demand and 
the cartelis in the process of disintegration. Almost every mem- 
ber of OPEC with the $exception of Saudi Arabia and Kuwait

cheats on prices. As a consequence, Saudi production has fallen 
to unsustainably low levels. Saudi influence within OPEC has 
declined in step with output. The only way Saudi Arabia could 
reassert control is by engaging in an all-out price war that would 
demonstrate the strength of its market position as gw-cost pro- 
ducer. But its market strength is matched by its political weak- 
ness. The result is a stalemate that leaves Saudi Arabia

immobilized. Market participants are bracing themselves for the 
impending storm, but in the meantime calm prevails. Spot prices 
are quite firm, because nobody wants to carry any inventory. The 
longer the pressures build, the more violent the storm is likely 
to be when it finally occurs. The supply curve is inverted. 
Most producers need to generate a certain amount of dol- 
lars; as the price falls, they will try to increase the amount sold

until the price falls below the point at which high cost producers 
can break even. Many of them will be unable to service their 
debt. The U.S. will be forced to introduce a protective tariff to 
save the domestic producers, and the protection is likely to be 
extended to Mexico, provided it continues to toe the line on the 
debt issue.

154 The Real-Time Experiment 
I have been carrying a short position in oil for quite a while and 
it has cost me a lot of money. Futures sell at a large discount from 
cash: carrying the position forward can cost as much as 2% a 
month. I am now inclined to close out the positions I hold in 
nearby months and establish a short position for next spring. The 
price would be lower, but the discount per month would also be 
lower. If my analysis is correct, the later the break comes the

bigger it will be. 
The views I have outlined here are sufficient to serve as a basis 
for what I call macroeconomic investment decisions. But they do 
not answer the question: what is going to happen to the Imperial 
Circle? On that issue, my crystal ball is cloudy. 
Other things being equal, the recession, if any, ought to be a 
mild one. Monetary policy has been eased even before we entered 
a recession; inventories are tightly controlled, and a declining

dollar should bring relief to the tradable goods sector, although 
the benefit may be felt only with a delay of 6 to 18 months. But 
other things are not equal. The financial structure is already under 
strain and it may not be able to withstand a recession: defaults 
could be self-reinforcing, both domestically and internationally. 
The financial authorities are fully aware of the danger and are 
determined to do everything in their power to prevent it. If it

comes to a choice between recession and inflation, the odds favor 
inflation. This is not a forecast, but a reading of current monetary 
policy. 
Inflation would not be all bad: it would make the burden of 
debt more bearable both by reducing real interest rates and by 
boosting commodity prices. The question is whether a policy of 
inflation could succeed. It is likely to elicit an allergic reaction 
from the financial markets, inducing a "flight from the dollar and a

rise in nominal interest rates. If foreigners become unwilling to 
finance our budget deficit, there must be a reduction in our GNP 
one way or another. But then, the Japanese may be willing to 
continue lending to us even if it provides them with a negative 
total return. 
MONDAY, SEPTEMBER 9,1985 
The experiment is off to a bad start. Currencies peaked shortly 
after I had taken my full position and plunged precipitously in 
the last three days. Bonds also peaked and fell. The rise in bonds

Phase 1 : August 1985-December 1985 155 
, Sept. 6,1985 
Closing % Change Closing % Change 
9/6/85 from 8/16 9/6/85 from 8/16 
DM 2.9235 - 6.9 S&P 500 188.24 + 1.1 
Y 242.10 - 2.3 US. T-Bonds 75"%2 - 1.6 
E 1.3275 - 5.2 Eurodollar 91.66 - .3 
Gold 320.70 - 5.1 Crude Oil 27.75 - 1.0 
QUANTUM FUND EQUITY $627,000,000 
Net Asset Value Per Share $4,238 
Change from, 8/16/85 - 3.2% 
Net Net 
Change Change 
' (21 12)

Net Net 
' (21 12) 
Investment from Net Currency from 
Positions (1) Long Shoe 8/16 Exposure (6) Long Short 8/16 
Stocks I DM-related 491 + 24 
US Stocks 653 (65) -16 Japanese Yen 308 + 64 
Foreign Pound Sterling 10 +1 
Stocks 163 -20 US Dollar (182) -109 
US Gvt. Currencies 45 -5 
Short 
Term (4) + 67 
J8+ Long 
Term + 46 
Commodities 
Oil (145) -24 
Gold 
was sufficient to scare me out of my small short position with a

loss, but 1 held on to my currency long positions on which I now 
also show a loss. The only thing that has worked in my favor is 
oil, where I used a strong market to extend my short positions to 
next spring. On balance, my trading has been poor, and I am 
losing heavily since the start of the experiment. Fortunately, the 
profits I made earlier this year leave me in a still comfortable 
position. 
The cause of the reverse is a spate of statistics that indicate an

156 The Real-Time Experiment 
clined, employment figures improved, as did retail sales. Auto 
I sales in particular exploded during the first ten days in which the 
auto companies offered concessionary credit terms. The evidence 
implies that the horse is drinking, after all. 
I am inclined to fight the evidence and if I look hard enough I 
can find enough quirks to explain most of the figures. One fact 
remains: the surge in auto sales is sufficient to justify the rather

aggressive production schedule auto companies have been work- 
ing on. Closer inspection shows that almost all the employment 
gains were auto related. The crucial question is: what is happen- 
ing to consumer spending as a whole? Are auto sales symptomatic 
of consumer behavior, or will they be offset by redtic-ugd exgeildi- 
tures in other areas? We shall only know the answer when it is 
I too late. 
For the time being, I am clinging to the view that the economy

is quite weak. The decline in the dollar has not been large enough 
to bring any relief to manufacturing. Agriculture is in worse shape 
than ever. Homebuilding could give the economy another boost 
-housing is primarily dependent on interest rates and employ- 
ment-but I believe that the fallout from the contraction of credit 
and erosion of collateral values as exemplified by the collapse of 
EPIC, the Equity Planning subsidiary of the Community Savings

& Loan Association of Maryland, is going to depress the construc- 
tion industry. Consumer debt is heavy, and strong auto sales now 
will reduce sales in the future. When 1986 models go on sale next 
month, the economy ought to slip back to the same position it 
was in before the auto companies started to force-feed it with 
promotional credit terms. 
The Federal Reserve is reluctant to tighten czedit because of 
the many weaknesses in the financial structure. If dollars are

being created faster than foreigners are willing to absorb them, 
the exchange rate ought to resume its decline-unless the econ- 
omy is strong enough to induce the Federal Reserve to tighten. 
It always comes back to the same question: the strength of the 
economy. 
Since I cannot resolve it, I shall be guided by the market. The 
German mark seems to have established a pattern that consists of 
a sharp rise, an equally sharp break, and a halfway retracing of

the decline followed by a period of consolidation. If the pattern 
holds, we ought to be at the bottom end of the second break. That 
would fit in well with my economic scenario. If the pattern is

Phase 1 : August 1985-December 1985 
DEUTSCHE MARK, DECEMBER 1985 r .390 
I 
8' 
PERCEIVED PATTERN 8* : 
Present moment 
PcblMarch 
Chart reprinted by permission from the weekly CRB Futures Chart Service. The FCS is a publication 
of Commodity Research Bureau, a Knight-Ridder Business Information Service. Editorial offices of CRB 
are located at 100 Church St., Suite 1850, New York, NY 10007. All material is protected by copyright 
and may not be reproduced without pennission.

and may not be reproduced without pennission. 
broken, I shall have to cut my exposure in half until I can reassess 
the economic scenario. This will inevitably result in a loss be- 
cause, if my expectations are correct, I shall not be able to reestab- 
lish my position without paying up, and, if I am wrong, I will

158 The Real-Time Experiment 
have an additional loss on the half position that I kept. That is the 
penalty I must pay for having taken too large a position at the 
wrong time. 
If my currency positions looked safer, I would consider buying 
some government bonds in the next refunding because real inter- 
est rates are once again reaching unsustainable levels, especially 
if Saudi Arabia is really going to step up oil production. 
My views on the longer term outlook are once again beginning

to veer toward the pessimistic side. The financial structure has 
sustained additional damage. I have already mentioned the EPIC 
story; the Farm Credit System has gone public with its problems; 
and the liquidity crisis in South Africa is establishing a new prec- 
edent that may encourage banks to act even faster the next time a 
similar situation arises. Although the U.S. economy is showing 
signs of strength, the position of our financial institutions is

weaker than it seemed a few weeks ago. 
SATURDAY, SEPTEMBER 28,1985 
We live in exciting times. The emergency meeting of the Group of 
Five finance ministers and heads of central banks at the Plaza 
Hotel last Sunday constitutes a historic event. It marks the official 
transition from a system of free floating to a system of managed 
floating. Readers of my chapter on reflexivity in currency markets 
will realize that I regard the change as overdue.

I managed to hang on to my currency positions by the skin of 
my teeth and after the meeting of the Group of Five last Sunday, I 
made the killing of a lifetime. I plunged in, buying additional yen 
on Sunday night (Monday morni~g in &ng Kong) and hung on 
to them through a rising market. The profits of the last week more 
than made up for the accumulated losses on currency trading in 
the last four years, and overall I am now well ahead.

What gave me the courage to hold on to my currency posi- 
tions was the pronounced weakness of the stock market. The 
strength of the dollar depends on the strength of the economy. A 
decline in stock prices can have considerable influence on the 
spending decisions of consumers and the investment decisions 
of those in business. Moreover, if there is going to be a reces- 
sion, it will be brought on by the decline in collateral values,

and the stock market is one of the most important repositories 
of collateral.

Phase 1 : August 1985-December 1985 159 
I Sept. 27,1985 
9/27/85 from 916 9/27/85 from 916 
DM 2.6820 +,8.3 S&P 500 181.30 - 3.7 
V 217.24 + 70.3 U.S. T-Bonds 75%~ + .1 
E 1.4190 +16.9 Eurodollar 91.71 + .1 
Gold 328.40 +,2.4 Crude Oil 28.93 +4.3 
QUANTUM FUND EQUITY $675,000,000 
Net Asset Value Per Share $4,561 
Change from 9/6/85 + 7.6% 
Change from 8/16/85 + 4.2% 
Net Net 
' Change Change

Net Net 
' Change Change 
(2) (2) 
Investment : from Net Currency ~m 
Positions (1) Long Short 916 Exposure (6) Long Short 916 
Stocks DM-related 550 + 59 
US Stocks 530 (85) -143 Japanese Yen 458 + 150 
Foreign Pound Sterling (44) -54 
Stocks 142 -21 US Dollar (289) -107 
US Gvt. Currencies 16 - 29 
Short & Term (4) 
Long 
Term (77) -77 
Oil (176) -31 
Gold 
The deutsche mark barely held within the perceived pattern

and my nerves were sorely tested, but by the time the Group of 
Five met, the mark had rallied in conformity with the perceived 
pattern. I am glad to report that the market reaction to the meeting 
broke the perceived pattern. Patterns are there to be broken by 
historic events and the meeting truly qualifies as one. 
The meeting was organized at the initiative of the Treasury. The 
Federal Reserve was brought in relatively late. Its main purpose

was to relieve the intensity of protectionist pressure. It was held

160 The Real-Time Experiment 
DEUTSCHE MARK. DECEMBER 1965 
I .390 
Chart reprinted by permission fmm the weekly CRB Futures Chart Service. The FCS is a publication 
and may not be reproduced without permission. 
on an emergency basis and no comprehensive policy was devel-

oped in advance. Still, a commitment was made and the policies 
will follow. How the currencies are going to be managed remains 
to be seen. Market intervention can be effective only in the short 
run: it needs to be backed up by other measures. In my opinion, 
most of the running will have to be done by the Japanese. In 
Japan, the central Esnk still has sufficient prestige and influence 
that it can move up the yen more or less at will; but, to keep it up,

the authorities will have to stem the outflow of capital and find 
additional domestic uses for savings by cutting taxes or increas- 
ing governmental expenditures or both. In addition, significant 
steps will have to be taken to remove nontariff barriers to im- 
ports. If not enough is done, the improvement in the yen will be 
difficult to maintain. 
The problem of the European currencies is different. Specula- 
tive flows are larger and the influence of central banks weaker.

The mark moved much less than the yen, indicating that spec- 
ulators and holders of liquid assets remain doubtful about the 
significance of the new departure. If the mark continues

DEUTSCHE MARK, DECEMBER 1885 
.390 
Chart reprinted by permiskion from the weekly CRB Futures Chart Service. The FCS is a publication 
of Commodity Research Bureau. a Knight-Ridder Business Information Service. Editorial offices of CRB 
are located at 100 Church St., Suite 1850. New York, NY 10007. All material is protected by copyright 

Japan, the central bank still has sufficient prestige and influence 

DEUTSCHE MARK. DECEMBER la85 
I .390 
are located at 100 Church St.. Suite 1850, New York, NY 10007. All material is protected by copyright 

Japan, the central bank still has sufficient prestige ad influence 

Phase 1 : August 1985-December 1985 161 
to appreciate, the difficulty will be in arresting the trend. It 
would not surprise me'if Volcker spent most of his time Sunday 
discussing not how to bring down the dollar, but how to arrest 
its fall. 
Since the meeting 1 have concentrated on the yen because that 
is the currency that matters as far as protectionist sentiment is 
concerned, but if the policy of intervention is successful, I intend

to stay with the mark'longer than with the yen. The yen will 
appreciate to a reasonable level, say 200 to the dollar, but the 
mark may become overvalued. Eventually, the real play may be 
in gold, especially in case of a recession in the U.S. 
Th action in ~tock~prices has been much worse &an, 1 ex- 
pected. In fact, I bought the S&P Futures after the Group of Five 
meeting for a trade and I had to liquidate the position with a loss.

Altogether, the market action is quite ominous. The erosion of 
collateral values seems'to be much worse than I anticipated a few 
months ago. I now believe that the economy will slip into a reces- 
sion before the measures now undertaken will have had time to 
bring relief. I also believe that additional measures will be forth- 
coming. Just as protectionist pressures brought a change in the 
exchange rate regime, the pressure of high real interest rates may

well bring a far-reaching arms agreement and d6tente at the No- 
vember summit. I am worried about the next six months, but I see 
better prospects for positive policy initiatives than at any time 
since the Imperial Circle came into existence. Odalance, I do 
not see much scope in taking a bearish posture in stocks, although 
I see a lot of merit in liquidity and I wish I had more of it. 
My short positions in oil have been going against me. The So-

viet Union cut back on deliveries and Kargh Islmd has been effec- 
tively put out of action. I decided to cover my short position for 
March and April by going long for January. The discount is the 
largest between now and January. Keeping a short position open 
has become very expensive. By buying for January, 1 have effec- 
tively stopped the clock; I intend to reestablish my short position 
later. 
SUNDAY, OCTOBER 20,1985 
The currency market has been rife with rumors of impending

action during the weekend or during Japanese Prime Minister 
Yasuhiro Nakasone's visit to the United States. I am inclined to

The Real-Time Experiment 
Oct. 18,1985 
10/18/85 from 9/27 10/18/85 from 9/27 
DM 2.6265 + 2.1 S&P 500 187.04 + 3.2 
# 214.75 + 1.1 U.S. T-Bonds 7622/32 + 1.5 
£ 1.4290 + .7 Eurodollar 91.80 + .1 
Gold 362.80 + 10.5 Crude Oil 29.52 + 2.0 
Japanese Bonds - 
QUANTUM FUND EQUITY $721,000,000 
Net Asset Value Per Share $4,868 
Change from 9/27/85 + 6.7% 
Change from 8/"11'85 + 11.2% 
Net Net 
(2) (21

Net Net 
(2) (21 
Positions (1) Long Short 9/27 Exposure (6) Long Short 9/27 
Stocks DM-related 680 + 130 
US Stocks 522 (148) -71 Japanese Yen 546 + 88 
US Index Pound Sterling (72) -28 
Futures (121) -121 US Dollar (433) -144 
Foreign Other 
Stocks 152 + 10 Currencies 34 + 18 
Bonds (3) us Gvt. 
Short 
Term (4) 
Long 
Term + 77 
Oil (37) +I39 
Gold 
discount the rumors. In fact, I am using the current strength to

somewhat reduce my short positions in the dollar. I intend to 
increase them further during the refunding period for U.S. gov- 
ernment bonds. 
Since the Group of Five meeting, there has been a lot of contro- 
versy between the Treasury and the White House, on the one 
hand, and the Federal Reserve on the other, some of which has

Phase 1 : August 1985-December 1985 163 
seeped into the press. ,The politicians seem to advocate "dirty 
intervention" in currency markets, while the Federal Reserve has 
religiously sterilized all the dollars it sold by selling an equivalent 
amount of Treasury bills. The politicians argue that sterilized 
intervention never works in the long run, but if the sale of dol- 
lars is allowed to increase the money supply the exchange rate

is bound to fall. Volqker's reply is that there is no need to 
be so aggressive because the dollar is going to decline any- 
how. If the markets are flooded with dollars, the dollar may go in- 
to a free fall that may be difficult to arrest. Volcker seems to 
be more concerned with preventing a collapse than with in- 
ducing a decline, and E sympathize with what 1 ticlieve ta be his 
position. 
If I were in his place I would keep interest rates stable until the

refunding is completed, selling foreigners all the dollars they 
want for the purchase of government securities, and I would 
lower interest rates after the auctions. This would ensure that the 
auctions are successful; and it would provide me with a large war 
chest to arrest the decline of the dollar when it has gone far 
enough. The economyqis very weak and both interest rates and 
the dollar need to be bought down. By waiting with an interest

rate reduction until after the auctions I could make a large-scale, 
sterilized sale of dollars at a level that would look very good 
later. 
It is this line of argument that prompts me to bysome dollars 
now. The market may be disappointed if there is no immediate 
action on interest rates, allowing the Federal Reserve to sell dol- 
lars at higher prices. That is when I want to increase my short 
position even furtiler. I am also interested in buying bocds in iire

refunding unless they go up too much in the meantime. I have not 
made any major moves in the stock market but I have whittled 
down my long positions and enlarged my short positions to a 
point where I seem to have a slight negative market exposure, 
although my long positions far outweigh my shorts in actual dol- 
lar amounts. I am increasing my short positions in Texas and 
California banks. 
SATURDAY, NOVEMBER 2,1985 
I got my timing wrong. My dollar sales looked good until the

Japanese central bank surprised me and the rest of the market by

164 The Real-Time Experiment 
1 Nov. 1,1985 
11/1/85 from 10118 11/1/85 from 10118 
DM 2.5910 + 1.4 S&P 500 191.48 + 2.4 
% 208.45 + 2.9 U.S. T-Bonds 7823432 + 2.6 
E 1.4415 + .9 Eurodollar 92.07 + .3 
' Gold 326.10 - 10.1 Crude Oil 30.39 + 2.9 
Japanese Bonds 92.75 
QUANTUM FUND EQUITY $759,000,000 
Net Asset Value Per Share $5,115 
Change from 1011 8/85 + 5.1% 
Change from 811 6/85 + 16.8% 
Investment Net 
Change

Change 
(2) 
from Net Currency Net 
Change 
(2) 
from 
Positions (1) Long Short ;0/18 Exposure (6j Long Short i0/18 
Stocks DM-related 630 - 50 us stocks 
US Index 
Futures 
Foreign 
Stocks 
Bonds (3) 
US Gvt. 
Short 
Term (4) 
Long 
Term 
Oil 
Gold 546 (148) +24 Japanese Yen 813 + 267 
Pound Sterling (88) -16 
(46) +75 US Dollar (596) -163 
Other 
209 + 57 Currencies 34 0 
raising short-term interest rates. I took this as the beginning of a

new phase in the Group of Five plan in which exchange rates are 
influenced not only by direct intervention but also by adjusting 
interest rates. Accordingly, I piled into the yen. When the yen 
moved, I also bought back the marks I had sold. I lost money on 
the trade but ended up with the increased position I wanted. At 
today's prices I have a profit on the maneuver.

Phase 1: August 1985-December 1985 165 
There is something unsound about increasing one's exposure 
in the course of a trend because it makes one vulnerable to a 
temporary reversal. It will be recalled that a reversal came close 
to making me disgorge my currencies at the wrong time earlier in 
this experiment. The reason I am nevertheless willing to increase 
my exposure is that I'believe that the scope for a reversal has 
diminished. One of thy generalizations I established about freely

floating exchange rates is that short-term volatility is greatest at 
turning points and diminishes as a trend becomes established. 
That is the case now. The fact that we are no longer in a system of 
freely floating exchange rates should diminish the risk of a rever- 
sal even further. Market particfpazta hava not y& recognized the 
new rules; the amount of exposure they are willing to carry is 
influenced by the volatility they have experienced in the past.

The same is true of me, or I would have reached my present level 
of exposure much earlier, and I would have made even more 
money on the move. By the time all the participants have ad- 
justed, the rules of thei game will change again. If the authorities 
handle the situation well, the rewards for speculating in curren- 
cies will become commensurate with the risks. Eventually, spec- 
ulation will be discouraged by the lack of rewards, the authorities

will have attained their goal, and it will be time for me to stop 
speculating. 
I have also missed the beginning of a move in bonds. When 
interest rates rose in Japan and to a lesser exteaP.in Germany, 
the market recognized that interest rates must fall in the United 
States and bond prices rose in anticipation. My well-laid plan of 
buying in the auction was preempted. I had to run after a mov- 
ing vehicle and climb aboard the best I could. So far, i kave-estzb-

lished a half position at not very good prices. I intend to double 
up in the next auction series in November. I must also consider 
increasing my stock market exposure for reasons that I shall 
explain. 
This is a good time to reassess the entire outlook. The contro- 
versy surrounding the Gramm-Rudman amendment has clearly 
demonstrated that public opinion is in favor of cutting the budget 
deficit. The Gramm-Rudman amendment was a brilliant device to

enable the president to cut programs that would be otherwise 
untouchable. The cuts would start to take effect after the 1986 
elections. The House of Representatives has gone one better by 
insisting that the cuts should start in the current fiscal year and

166 The Real-Time Experiment 
fall more heavily on defense. The Senate version would have 
4 favored the Republicans in the 1986 election, but the House Dem- 
ocrats turned the table by exempting many social programs and 
bringing forward the effective date. The White House is in a quan- 
dary: it must do something about the budget deficit in order to 
pave the way to lower interest rates, but to raise taxes before the 
1986 elections would be suicidal. There is a way out: to reach

some accommodation with the Soviet Union at the summit meet- 
ing and reduce defense spending. The budget issue would be 
resolved and the Republicans could run in the 1986 election as 
the party of peace. It remains to be seen whether Reagan is inter- 
ested in this soluiion. 
If it came to pass, we would enter a phase of great prosperity 
4 with lower interest rates, a lower dollar, and a stock market boom. 
The enthusiasm generated by these moves would help to get the

economy going again and the Baker Plan announced at the recent 
annual meeting of the World Bank in Seoul would help to keep 
the heavily indebted countries from collapsing. Mergermania 
would receive one last push from lower interest rates but it would 
eventually run out of steam because rising stock prices would 
make new deals uneconomic. With the benefits of corporate re- 
structuring, profits would soar in a more benign environment and,

with the shrinkage of equity capital that has occurred, stock 
prices could go through the roof. Eventually, the boom would be 
followed by a bust in which the uneconomic deals come apart 
and the international debt problem also comes back to haunt 
us, but stock prices would have to rise before they can collapse. 
That is why I am contemplating raising my stock market expo- 
sure. 
We are approaching the moment of truth. If Reagan flubs his

opportunity, the consequences could be serious. We are hovering 
on the edge of a recession and we need both lower interest rates 
and a lower dollar to prevent an unraveling of credit. Even then, 
quite a lot of monetary stimulation may be needed to get the 
economy going again. It takes time for the decline in the value of 
the dollar to bring relief from import competition. In the first 
instance, the expectation of higher prices may divert domestic

demand to imported goods. Only a significant drop in short-term 
interest rates, accompanied by better bond and stock prices, could 
reverse sentiment in time to prevent a recession. Without an 
agreement on Gramm-Rudman, the bond market could be disap-

Phase 1 : August 1985-December 1985 167 
pointed, the Federal Reserve would be reluctant to lower interest 
rates aggressively, and the erosion in collateral values would con- 
tinue. 
The collapse of the International Tin Council provides a perfect 
illustration of the erosjon of collateral values. The collapse of 
OPEC is only a matte; of time now. I am increasing my short 
positions in oil for Jqnuary to March delivery. By the same

token I am buying oil-refining stocks, because the increased flow 
should help their margins. As for the big picture, the next 
couple of weeks will tell the tale. The summit meeting is on 
November 19 and thelbudget debate has to be resolved before 
the nextaauction can take place. That is W~JJ I have decided 
to wait until the auction before taking a full position in 
bonds. 
SATURDAY, NOVEMBER 9,1985 
My views on currencies are being tested. After a sharp rise in

the yen, there was a sharp reversal last Thursday. I was told 
that the Bundesbank had bought dollars below DM 2.60 but it 
sold them again at DM 2.645 on Friday. In accordance with my 
contention that there is less risk in the market I refused to be 
panicked. 
The bond market is poised for a breakout on the upside. There 
are large option positions in Treasury bond futurss that expire 
next Friday. If the futures price moves above 80 before then, I

intend to sell all or part of my position, because I believe the 
market is vulnerable. The White House cannot compromise on 
the budget befose the summit on November 19 and the Democrats 
will continue to press their advantage. This means a stalemate for 
the next week or so, followed by an auction as soon as it is re- 
solved. I would be happy to withdraw from the market with a 
profit, putting me in a strong position to buy at the time of the 
auction.

auction. 
The stock market has also been strong. Divergences have per- 
sisted but the market broadened out on Friday. A breakout in 
bonds could coincide with a temporary top in the stock market, 
to be followed by a correction. I want to use that opportunity to 
cover my shorts and prepare to take a long position. If the correc- 
tion does not occur, I shall cover my shorts with a loss and if the 
summit is successful go long at higher prices.

Nov. 8,1985 
11/8/85 from 11/1 1 1/8/85 from 1 1 11 
DM 2.6220 - 1.2 S&P 500 193.72 +1.2 
Y 205.50 + 1.4 U.S. T-Bonds 792Y32 + 1.2 
E 1.4170 - 1.7 Eurodollar 92.14 + .1 
Gold 324.20 - 0.6 Crude Oil 30.45 + .2 
Japanese Bonds 93.70 +1.0 
QUANTUM FUND EQUITY $782,000,000 
Net Asset Value Per Share $5,267 
Change from 11/1/85 + 3.0% 
Change from 8/16/85 + 20.3% 
Net Net 
Change Change

Net Net 
(21 (2) 
Investment from Net Currency hm 
Positions (1) Long Short 1111 Exposure (6) Long Short 1111 
Stocks DM-related 654 + 24 
US Stocks 569 (127) +44 Japanese Yen 806 -7 
US Index Pound Sterling (86) +2 
Futures +46 US Dollar (592) +4 
fjtocks 206 - 3 Currencies 42 +8 
Bonds (3) 
US Gvt. 
Short 
Term (4) 82 + 54 
Long 
Term 498 + 42 
Oil (187) -1 
Gold 
SATURDAY, NOVEMBER 23,1985

Gold 
SATURDAY, NOVEMBER 23,1985 
The markets continue to preempt me. Both stocks and bonds rose 
strongly in advance of the summit meeting and the buying oppor- 
tunity I was waiting for in connection with the government bond 
auction did not materialize. Instead of selling my bonds, I in- 
creased my position and I also bought some stock index futures

Phase 1 : August 1985-December 1985 169 
1 
Nov. 22.1985 
Closing % Change 
11/22/85 from 1118 Closing % Change 
11/22/85 from 1118 
DM 2.5665 + 2'1 SW 500 201.52 + 4.0 
Y 201.00 +2,2 U.S. T-Bonds 802% +1;5 
E 1.4640 + 3:3 ~~rodollar 92.02 - .1 
Gold 326.90 + ,8 Crude Oil 30.91 + 1.5 
I Japanese Bonds 94.80 + 1.2 
QUANTUM FUND EQUITY $841,000,000 
Net Asset Value Per Share $5,669 
Change from 11/8/85 + 7.6% 
Change from 8/16/85 + 29.5% 
Net Net

Net Net 
I Change Change 
(21 (2) 
Investment , from Net Currency from 
Positions (1) Long Short 1118 Exposure (6) Long Short 111'8 
Stocks DM-related 668 + 14 
US Stocks 664 (83) +I39 Japanese Yen 827 + 21 
US Index Pound Sterling (87) -1 
Futures 126 + 126 US Dollar (567) +25 
Stocks 251 + 45 Currencies 40 -2 
Bonds (3) 
US Gvt. 4 
Short 
Term (4) 105 + 23 
Long 
Term 969 + 471 
Japanese 
(5) 354 + 354 
Oil (214) -27 
Gold

Gold 
because I did not want to miss a strategic opportunity on account 
of a tactical error. 
I also took a significant position in Japanese bond futures. This 
is a new market in which I have no previous experience, but the 
market participants I compete with must have even less experi- 
ence. The Japanese bond futures market collapsed (from 102 to

170 The Real-Time Experiment 
92) when the Japanese government raised short-term interest 
t rates. Experience has taught me that the best buying opportunities 
in long-term bonds present themselves when the yield curve is 
inverted-which is the case in Japan today. The rise in Japanese 
interest rates is bound to be temporary: the Group of Five wants 
to stimulate worldwide economic activity, not to dampen it. A 
reduction in U.S. interest rates would be matched by the other

major industrial countries and, if the impact on exchange rates 
can be neutralized, the reduction may go further than currently 
envisioned. I am making the same bet in Japan as in the U.S. and 
the odds seem even better. 
I sm now fully invested in all directions: stocks, bonds, and 
currencies. I would have obtained better prices if I had not tried 
I to finesse it, or if the finesse had worked-but the main thing is 
that I reached the posture I wanted. I am looking for an opportu-

nity to shift from bonds to stocks but I consider it prudent not to 
increase my overall exposure any further. 
Events have unfolded more or less as I expected. The only 
hitch was in the Gramm-Rudman amendment. Congress passed 
a one-month extension of the debt ceiling, enabling the auc- 
tion to go forward while the fate of Gramm-Rudman remains un- 
resolved. 
The summit meeting lived up to my expectations. I believe a 
radical shift in U.S.-Soviet relations is in the making. Both sides

need to reduce their military spending and both sides have much 
to gain from closer cooperation. The opportunity was there and 
President Reagan seized it. By not making any concessions on 
Star Wars, Reagan has put himself in a position to usher in an- 
other period of detente without exp~sing himself to criticism for 
selling out to the Russians. In this context, the Gramm-Rudman 
amendment may come in positively useful as a mechanism for

cutting the military budget without appearing to want to. The 
most eminently cuttable part of the military budget is retirement 
benefits-Stockman made an impassioned plea on the subject be- 
fore quitting-and Gramm-Rudman may provide the perfect ex- 
cuse. I expect a fairly stiff version of Gramm-Rudman to be 
enacted-one that is closer to the House version than to the Sen- 
ate. In the present setting, that would no longer be as detrimental

to the Republicans' election chances in 1986 as it seemed a few 
weeks ago. 
Gramm-Rudman would be followed by a discount rate cut in

Phase 1 : August 1985-December 1985 171 
short order. That is what makes me take on the maximum expo- 
sure in bonds at the piesent time. I realize there may be some 
indigestion in the market after the auctions, but if my analysis is 
correct there is still something left to go for. 
After a discount rate c;ut I intend to cut my bond exposure and 
increase my stock positions. Stocks are more open-ended on the 
upside than bonds. If and when the economy rebounds, stocks

will do better than bonds. If the economy continues to languish, 
the reduction in short-term interest rates may go much further 
than currently expected, but the dollar would also come under 
pressure so that the yield curve is likely to steepen. It should be 
remembered that d6tente is bearish fa: the dollas vis-l-vis Euro- 
pean currencies. If one wants to stay in bonds, the place to be is 
the short end. 
We may be on the verge of a great stock market boom. Industrial

companies have suffered from a combination of inadequate prices 
and inadequate demand. These adverse conditions have resulted 
in the wholesale restructuring of corporate America. Many com- 
panies have been swallowed up by takeovers and leveraged buy- 
outs. Those which have survived have tightened their belts, 
disposing of losing divibions and cutting corporate overhead. Pro- 
ductive capacity has been cut rather than increased, and market

share has been concenti-ated in fewer hands. The lower dollar is 
now in the process of relaxing pricing pressures; if there is any 
pickup in demand, it goes straight to the bottom lb. Lower in- 
terest rates and the lower inflation rate combine to make a given 
level of earnings more valuable. After a period when industrial 
shares were selling at a discount from their breakup value we may 
enter a period when they once again sell at a premim. But before

we get there, we are likely to experience another wave of take- 
overs, induced by the decline in interest rates. 
END OF PHASE 1: SUNDAY, DECEMBER 8,1985 
This may be a good point to terminate the real-time experiment. 
I have assumed maximum market exposure in all directions 
and I have also announced my intention to shift gradually from 
bonds to stocks within the constraints of prudence. At present 
a large part of my stock market exposure is in the form of index

futures. With the passage of time I shall try to develop specific 
stock investment concepts, and my performance will be increas-

172 The Real-Time Experiment 
t 
Dee. 6,1985 
12/6/85 from 1 1/22 12/6/85 from 1 1 122 
DM 2.5115 + 2.1 S&P 500 212.02 + 5.2 
% 202.10 - .5 U.S. T-Bonds 8328/92 + 3.7 
E 1.4425 - 1.5 Eurodollar 92.33 + .3 
Gold 322.30 - 1.4 Crude Oil 28.74 - 7.0 
Japanese Bonds 99.21 + 4.7 
QUANTUM FUND EQUITY $867,000,000 
Net Asset Value Per Share 
I Portfolio Structure (in inillions of dollars) 
Net Net 
(21 (2) 
Investment from Net Currency *m

(21 (2) 
Investment from Net Currency *m 
Positions (1) Long Short 11/22 Exposure (6) Long Short 11/22 
Stocks DM-related 729 + 61 
US Stocks 724 (72) +71 Japanese Yen 826 -1 
US Index Pound Sterling (119) -32 
Futures 368 + 242 US Dollar (569) -2 
Stocks 271 +20 Currencies 33 -7 
Bonds (3) 
US Gvt. 
Short 
Term (4) 90 - 15 
Long 
Term 661 - 308 
Japanese 
(5) 300 - 54 
Oil (150) +64 
Gold 
ingly influenced by the validity of those concepts. To keep

a detailed account of my investment activities beyond this point 
would take us too far afield from the subject of the experiment, 
namely, predicting the future of the Imperial Circle. I shall 
continue my periodic diary but it will serve the purpose of 
control and not of formulating a prediction. In other words, I 
wish to "freeze" my expectations about the future of the Imperial

r 
I , h. 6,1985 
12/6/85 from 1 1 122 12/6/85 from 11/22 I DM 2.5115 . +2.1 SBrP 500 212.02 + 5.2 
ingly influenced by the validity of those concepts. To keep 
continue my periodic diary but it will serve the purpose of

wish to "freeze" my expectations about the future of the Imperial * 202.10 , - .5 U.S. T-Bonds 832% + 3.7 
E 1.4425 -1.5 Eurodollar 92.33 + .3 
Gold 322.30 -1.4 Crude Oil 28.74 - 7.0 
I Japanese Bonds 99.21 + 4.7 
Net Asset Value Per Share $5,841 
Change from 11/22/85 + 3.0% 
Change 
(2) 
Change 
(21 
from

(2) 
Change 
(21 
from 
Positions (1) Long Short 11/22 Exposure (6j Long Short i 1/22 
US Stocks 724, (72) + 71 Japanese Yen 826 -1 
Short 
Long 
Term 66; - 808 
Japanese 
(5) 300 - 54 
Oil (150) + 64 
Gold

12/6/85 from 11/22 12/6/85 from 11/22 
rY 202.10 - .5 U.S. T-Bonds 83%~ + 3.7 
Japanese Bonds 99.21 +4.7 
I Portfolio Structure (ia millions of dollars) 
Net Net 
(2) (21 
Investment from Net Currency from

(2) (21 
Futures 368 +242 US Dollar (569) -2 
Stocks 271 + 20 Currencies 33 -7 
Bonds (3) 
US Gvt. 
Short 
Long 
Japanese 
(5) 300 - 54 
Gold 

Phase 1 : August 1985-December 1985 173 
Circle at the present time and submit it to the test of events. 
Needless to say, I shalt continue changing my portfolio as I see 
fit. 
I have about as firm a conviction about the shape of things to 
come as I shall ever hgve, as witnessed by the level of market 
exposure I am willing t'o assume. At the beginning of the experi- 
ment 1 said that my crygtal ball about the longer term outlook was

rather cloudy. The experiment has brought about a remarkable 
transformation: I now have a relatively clear vision of the future 
and that vision differs significantly from the admittedly tentative 
views I started with. I regarded the Imperial Circle as a temporary 
expedient whose internal contmdictions were bOu~d to render .it 
unsustainable, and my presumption was that the problems that 
the Imperial Circle had managed to keep at bay would resurface

with renewed vigor after its disintegration. Specifically, the Im- 
perial Circle constituteil an artificial extension of the period of 
credit expansion with the U.S. government acting as "borrower of 
last resort." When the Imperial Circle ceased to attract capital 
from abroad in ever-inbreasing quantities, the last engine of eco- 
nomic stimulation would be extinguished, and the contraction of 
credit would create an'untenable situation. Without a significant

expansion of money supply the burden of debt would become 
unbearable; with a significant expansion, the dollar would go into 
a free fall. 
I am now beginning to discern the outlines of awther tempo- 
rary solution that may succeed in unwinding the excesses of the 
Imperial Circle without plunging us into a vicious circle. The 
solution consists of switching from fiscal to monetary stimulation 
in the United States and controlling the descent of the dollar

through international cooperation. The new constellation is al- 
most the exact opposite of the Imperial Circle: a weaker dollar 
and a subdued economy are accompanied by lower budget and 
trade deficits and, most important, by lower interest rates. With 
the help of a weaker dollar, prices are going to rise somewhat 
faster than previously, rendering the change in real interest rates 
all the more pronounced. Declining real interest rates, together

with a possible pickup in exports, will replace the budget deficit 
as the main driving force in the economy. Rising prices will help 
to counteract the erosion of collateral values and prevent a self- 
reinforcing, deflationary process from taking hold. At the same 
time, the coordination of economic policies will keep the decline 
of the dollar within bounds, thereby eliminating the possibility of

174 The Real-Time Experiment 
a self-reinforcing inflationary process. The outcome would be a ' greater degree of stability than we have experienced since the 
breakdown of Bretton Woods. 
Using the notation adopted earlier, we can depict the key rela- 
tionship in the newly emerging state of affairs as follows: 
The picture is much simpler than that of the Imperial Circle be- 
exchange rates are stabilized. The extent to which interest

rates will decline depends on the amount of stimulation that will 
I be necessary to keep the economy from sliding into a reces- 
sion. 
Although the new constellation is almost the exact opposite of 
the Imperial Circle, there is one essential difference between 
them. The new constellation is the deliberate outcome of a con- 
certed economic policy, whereas the Imperial Circle was the un- 
intended consequence of conflicting economic policies. The

Imperial Circle was self-reinforcing until it became excessive and 
ripe for a reversal; the reversal would also become self-reinforcing 
unless it were deliberately controlled. The mechanism of control 
is the management of exchange rates in the first instance and the 
coordination of monetary and fiscal policies in the second. 
It is the emergence of a concerted economic policy that has 
caused me to change my expectations in the course of the experi-

ment. I was aware of the possibility of such a policy emerging and 
I stressed the difference between the first and the second Reagan 
administrations. During the three months of the experiment, there 
occurred several historic events that converted a mere possibility 
into a historical reality: the Group of Five meeting, the Baker 
speech in Seoul, the Grarnm-Rudman amendment and the summit 
meeting in Geneva. 
What makes the emergence of the new economic direction so

fascinating is that the actual policy measures of which it will be 
made up have not even been formulated. The Group of Five meet- 
ing was merely a commitment to follow a coordinated exchange 
rate policy, not an agreement on what that policy is; the Baker 
Plan for international debt is certainly not a plan but merely the 
announcement of a need for a plan; the summit meeting may mark 
a new departure in relations between the superpowers, but it pro-

Phase 1 : August 1985-December 1985 175 
duced no concrete results; and the fate of the Gramm-Rudman 
amendment is still uncertain at the time of writing. 
The actual policies are yet to be formulated. How far they will 
reach will depend partly, on the farsightedness of the policymak- 
ers but mainly on the pressure of necessity. Necessity may be 
defined in this context as the need to preserve the integrity of the

financial and trading sy tems, or, in other words, to forestall a k collapse in credit and to eep protectionism at bay. The definition 
is rather cavalier: it does not rule out individual defaults or par- 
ticular instances of trade restraint; the crucial issue is that neither 
Success is far from assured. Past experience is not encouraging. 
A somewhat similar set of circumstances led to the collapse of 
both credit and international trade in the 1930s. But exactly be-

cause the memory of the: 1930s is still so vivid, the prospect that 
we shall avoid similar mistakes is rather favorable. There is gen- 
eral agreement on some policy objectives: a controlled descent of 
the dollar and a concerted reduction in interest rates. There is less 
agreement on other points: how to reduce the U.S. budget deficit 
and how to stimulate the economies of the debtor countries. It is 
difficult to obtain concerted action even on the generally agreed

objectives. For instance; Japan was obliged to raise interest rates 
because the United States was unable to resolve the issue of the 
budget deficit in time. How can one have any cddence that 
appropriate action will be taken in those areas where even the 
agreement on objectives is missing? 
Clearly, the situation is far from riskless, and, as we shall see, 
'-3use the risks are the greatest in the short term. It is exa~tly be,

the risks are so great, and their severity is recognized, that one 
can have a fair degree of confidence that the necessary measures 
will be forthcoming. I am not the only one to think so: the finan- 
cial markets have endorsed the new policy departure in no uncer- 
tain fashion. The rise in bond and stock prices is helpful in two 
ways: it encourages the authorities to pursue the course on which 
they have embarked, and it enhances the chances of success. For

instance, the strength of the bond market enlarges the Federal 
Reserve's freedom of action in lowering interest rates. We are 
dealing with a reflexive process where the direction of economic 
policy and the direction of the financial markets mutually rein- 
force each other. 
It is the response of the financial markets that has given me the

176 The Real-Time Experiment 
courage to take on such a large market exposure. It will be recalled 
t that in the case of currencies when the change in trend was still 
uncertain I was much more tentative and when the market moved 
against me I was a hair's breadth away from cutting back my 
position. In fact, the real-time experiment was instrumental in 
helping me to hang in there because seeing my ideas clearly for- 
mulated strengthened my convictions. My success in the market-

place has reinforced my confidence in my ability to predict the 
course of events even further. 1985 is shaping up as a record- 
breaking year for Quantum Fund: a more than 100% appreciation 
within a year is heady stuff. I have to be careful. Using the concept 
of reflexivity to predict the -future course of events is itself a re- 
flexive process, and a high degree of success is often the precursor 
to a severe setback. It is clear from the experiment that my percep-

tions are partial and subject to correction by events. If I begin to 
lay store on my longer term expectations-and what is worse, go 
public with them-I may be setting myself up for a great fall. It is 
a danger I intend to guard against. It will be interesting to see, 
when we control the experiment, what will have remained of my 
current game plan. 
Actually, it is less dangerous to cany a large market exposure 
at the present juncture than to predict the eventual outcome of

the policies that are now being formulated. The mere fact that 
there is an attempt to take charge of the world economy is suffi- 
cient to give the financial markets a boost and, even if the hopes 
are going to be disappointed, it will take time for the failure to 
become evident; thus the attempt at a concerted policy should be 
sufficient to sustain the present rally for a while. The eventual 
outcome is quite another matter. There can be no assurance that

the market's expectations will be fulfilled. I must beware not to 
allow my confidence in a bull market to affect my judgment about 
the real world. I have become so involved in the market that I find 
it difficult to maintain perspective. 
I shall try to assess the future of the Imperial Circle in two 
different ways: one is to identify the "thesis" that the current 
market rally incorporates and evaluate its chances of success; the

other is to locate the present moment within the theoretical 
framework of credit expansion and contraction that I have been 
trying to formulate. Both approaches employ the concept of re- 
flexivity, but the first one sticks closely to the reflexivity inherent 
in financial markets while the second seeks to explore the reflex-

Phase 1 : August 1985-December 1985 177 
ive connection betweep credit and collateral values. Needless to 
say, I am on much surer grounds with the first approach. 
I believe the market has come around to the view that the econ- 
omy is fundamentally, weak and inflation nonexistent. A brief 
rally in cyclical stockslin early summer has petered out and the 
highs reached then have still not been surpassed. That rally has 
been based on the mistaken expectation of an imminent pickup

in the economy, and it was very narrow: other segments of the 
stock market were declining while the cyclicals rose. It was fol- 
lowed by a general market decline that was cushioned by takeover 
and stock buy-back activity. Commodities also made new lows 
and have been lagging Sn the current recovery. Metals, in particu- 
lar, have acted very poorly in relation to currencies. 
The recent stock market rally is much more broadly based than

the earlier flurry in cyclicals; it follows on the heels of a bond 
market rally and it was preceded by a decline in the dollar. Ob- 
viously the markets are discounting a decline in the economy. 
Whether it will deteri~rate further is an open question. Econo- 
mists are almost unanimous in ruling out a recession, but the 
stock and bond markets are acting as though it were an accom- 
plished fact: stock prices are rising because investors are "looking

across the valley." It is possible that the slowdown of the past 
year served as the equivalent of a recession; alternatively, there is 
some further weakness to come. Either way, the sequence of 
events is highly unusual and investors have beedaken by sur- 
prise: none of the technical indicators that normally signal a sig- 
nificant upturn in the stock market has been present. The 
November 27 lead article in the Wall Street Journal entitled 
"Strange Rally" has highlighted this fact.

"Strange Rally" has highlighted this fact. 
Every recession since the end of the Second World War has 
been preceded by the Federal Reserve tightening the money 
supply, causing an inverted yield curve to appear at some point 
along the line. An inverted yield curve preceded the rally in 
the summer of 1982, but we have not seen an inverted yield 
curve since. The explanation for the current sequence of 
events has to be sought elsewhere. That is where the second

approach using my hypothesis about the credit cycle comes in 
handy. 
It will be recalled that I envision a reflexive relationship be- 
tween the act of lending and the value of the collateral that serves 
as security for the loans. Net new lending acts as a stimulant that

178 The Real-Time Experiment 
enhances the borrowers' ability to service their debt. As the 
amount of debt outstanding grows, an increasing portion of new 
lending goes to service outstanding debt and credit has to grow 
exponentially to maintain its stimulating effect. Eventually the 
growth of credit has to slow down with a negative effect on col- 
lateral values. If the collateral has been fully utilized, the decline 
in collateral values precipitates further liquidation of credit, giv-

ing rise to a typical boomlbust sequence. 
Using this model, I contend that the postwar period of credit 
expansion has run its course and we are now in a period of credit 
contraction as far as the real economy is concerned. All previous 
postwar recessions occurred during the expiillsiontuy phase: that 
is why they had to be induced by tight money. We are now in the 
contractionary phase where a slowdown need not be induced: in

the absence of new stimulants, such as a growing budget deficit, 
the erosion of collateral values will do the job. 
The trouble is that real life is not as simple as the model I have 
been working with. In particular, the transition from credit expan- 
sion to credit contraction does not occur at a single point of time 
because it would precipitate an implosion that the authorities are 
determined to prevent. Official intervention complicates matters.

The turning point does not occur at a single moment of time, but 
different segments of the credit structure follow different time- 
tables. To locate our position in the credit cycle, it is necessary to 
disaggregate the process and consider the main elements of credit 
separately. 
This approach yields 1982 as the turning point for the heavily 
indebted countries, 1984 as the turning point for U.S. financial 
institutions, and 1986 as the turning poi& for the U.S. budget

deficit. The contraction of credit in less developed countries has 
probably reached its peak in 1984; the adjustment process is 
largely responsible for the oversupply of basic commodities. The 
adjustment process by U.S. banks and savings and loan institu- 
tions has only recently begun to make its effect felt on collateral 
values in real estate, land, shipping, and the oil industry. The 
reduction in the budget deficit has not yet taken effect and it is to

be expected that it will be fully compensated for by a reduction 
in interest rates. Two more important pieces need to be fitted into 
the jigsaw puzzle: mergermania and consumer spending. 
Leveraged buyouts and other manifestations of mergermania 
are great users of credit but they tend to produce a corresponding

Phase 1 : August 1985-December 1985 179 
amount of liquid assets. Superficially, they seem to be expansion- 
ary but in fact they fit into the declining phase of the credit cycle: 
they increase the total amount of debt without stimulating the 
economy. Cash flow is, used to service debt rather than to pur- 
chase physical assets; t$e disposal of assets adds to the downward 
pressure on collateral dalues; and the sale of junk bonds tends to

steepen the yield curve: the net effect on the economy is depress- 
ing rather than stimulafing. 
Consumer spending is the great unknown. Consumer indebt- 
edness has been rising steadily over the years, and repayment 
terms have been extended to a point where it is hard to see 
how they can be extended cny further. Until recently, houses 
could be bought with a 5% down payment and auto loans could 
be repaid over five years. Delinquencies in consumer loans have

risen ominously in the course of 1985, but the simultaneous 
decline in interest rates and the dollar should alleviate the 
situation. Will these ,developments merely serve to contain 
the delinquency problem, or will they stimulate new demand? 
That is the crucial question on which the near-term outlook 
hinges. 
If consumer spending remains sluggish, the bull market in 
bonds and stocks may have considerable staying power; in fact,

we could have one of the great bull markets of all times. A pickup 
in the domestic savings rate would offset the reduction in the 
inflow of foreign capital allowing interest rates to dgcline in spite 
of the decline in the dollar. The stock market would benefit from 
both developments. Lower interest rates would enhance the value 
of a given level of earnings, and the lower dollar would enhance 
the level of earnings by mitigating pricing pressures from imports.

In a sluggish economy the cost of labor would remain depressed. 
Threatened by adverse economic conditions and corporate take- 
overs, managements have redeployed assets and reduced over- 
head expenses; as conditions improve, the benefits flow directly 
down to the bottom line. As interest rates decline, there would be 
one last rush of corporate takeovers and leveraged buyouts, in the 
course of wh'ch exaggerated prices may be paid; but recent events

make past a quisitions more viable and deals that may have been 
unsound w 1 en consummated are now looking healthier. Even- 
tually the hise in stock prices should render leveraged buyouts 
uneconomic, and merger activity should peter out. That would be 
a very p'ositive development for the real economy because it

180 The Real-Time Experiment 
would enhance the attraction of investing in physical assets stim- 
4 ulating not only demand but also supply. Should we reach that 
point, our economy would be healthier than it has been for some 
time. The boom may eventually get out of hand and set us up for 
a great crash, but share prices would have to rise a great deal 
before we reach that point. It is an argument for buying stocks 
now. 
On the other hand, if consumer spending does pick up under

the impetus of lower interest rates, the boom in financial markets 
will be short-lived and the real economy is likely to follow the 
stop-go pattern familiar from the British example. With inade- 
quate domestic savings and doaesti~ iaveshnent, the excess of 
both credit and consumption would have to be met from abroad 
4 and we would be back in the situation that prevailed at the end 
of the Imperial Circle. Either we raise interest rates, restarting the

Imperial Circle and choking off the domestic economy, or we 
print money, setting in motion a vicious circle in the opposite 
Reality is likely to fall between these extremes, but that is not 
saying much because the extremes open up an almost infi- 
nite range of possibilities. I am no better qualified to predict con- 
sumer behavior than I was at the beginning of the experiment. 
All I can do is evaluate the consequences of the various alterna- 
tives.

tives. 
It can be seen that a period of subdued consumer spending 
could do much to correct the last two major areas of excess credit. 
Mergermania would run out of steam as the stock market rises 
and the overindebtedness of consumers would be corrected as the 
savings rate rises and lenders tighter1 their criteria. Mer a while, 
conditions would-be ripe for more balanced growth. 
When past excesses are being corrected it is always a period of

maximum risk. That is the case now. There have already been a 
number of minor catastrophes: the EPIC debacle has been fol- 
lowed by others in the real estate lending arena; the Federal Sav- 
ings and Loan Insurance Corporation and the Farm Credit Sys- 
tem have gone public with their woes; the International Tin 
Council has been unable to meet its obligations, tin trading on the 
London Metal Exchange has been suspended, and many metal

traders are going out of business; the largest Japanese shipping 
company has gone broke; just now the Singapore Stock Exchange 
has had to close for a few days; and there are obviously other

Phase 1: August 1985-December 1985 181 
events yet to come. We are facing at least two shocks that exceed 
in magnitude anything we have experienced to date. One relates 
to oil, the other to international debt. 
The collapse of oil prices is only a matter of time. Once it begins 
it will not stop of its owh volition. Most countries operate with a 
perverse supply curve: ihe lower the price of oil, the more they 
need to sell in order to meet their needs. Left to itself, the price of

oil could temporarily fall to a single digit, but it will not be left to 
itself. Domestic industry will have to be protected below $22, 
otherwise the losses would exceed the capacity of the banks to 
absorb them. I would expect to see some kind of protection that 
woukl also extend to Mexico and Canada. I wonder how the 
North Sea producers will be protected. The problem will be a 
difficult one for the European Economic Community to resolve.

How it is dealt with may determine the future of the Common 
Market. 
The problem of international debt has not gone away. Indeed, 
the debt of the less developed countries has continued to grow, 
although some countries have been able to improve their debt 
ratios. Negative resource transfers probably reached their peak in 
1984 and, as debtor countries insist on reflating their economies, 
negative resources transfers are beginning to decline. The cohe-

sion of the lenders' collective has eroded. The run on South Af- 
rica, in particular, has driven a wedge between American and 
European banks. In the United States, the interests omoney cen- 
ter banks and regional banks diverge. The Baker Plan demon- 
strates an awareness of the problem but it falls far short of a 
solution. Until a solution is developed, the system remains acci- 
dent prone, although it is not clear where the next accident is

likely to occur. The banking system is now strong enough to with- 
stand a single shock; the danger is that several shocks may coin- 
cide. - 
There is yet a third danger that will develop as the stock market 
boom gathers momentum: the danger of a crash in the stock mar- 
ket. At present, market participants are still very conscious of the 
problems and as a consequence are quite liquid. But it is in the 
nature of a boom that it attracts ever-increasing amounts of credit.

If a financial shock occurs when many stock market participants 
are overextended, margin liquidation could cause an implosion 
of stock prices. We are a long way from that stage: at present, a 
sudden financial shock, like the failure of yet another bank, could

182 The Real-Time Experiment 
cause a short, sharp break in prices, but the market would recover. 
I The bull market is likely to be punctuated with such breaks until 
participants will cease to fear them. That is when we shall be set 
up for a crash. 
The financial system has been severely tested and the testing 
is not yet over. The fact is that the system survived and the re- 
cent changes in economic management improve the chances

that it will continue to survive. The process of credit con- 
traction has been accomplished without a bust so far and one 
can now see a way in which it could be completed without a 
bust, albeit at the cost of a prolonged period of substandard 
growth. 
Substandard growth is less than desirable almost by definition, 
4 but it may meet the policy objectives of the present administra- 
tion perfectly. It has been long recognized that conditions in

which goods and services are freely available are more rewarding 
to the owners of capital than conditions in which resources are 
fully employed. Not only does a larger share of the national prod- 
uct accrue to the owners of capital but entrepreneurs enjoy much 
greater freedom of action. That is certainly the case today. The 
reins of government are in the hands of people who believe in 
free enterprise and encourage it to the greatest possible extent or 
even beyond.

even beyond. 
Incidentally, Japan has also found it advantageous, for different 
reasons, to expand its economy at a rate that is decidedly below 
its potential. Japan wants to become a great power in the world 
and the way to achieve that status is not by encouraging domestic 
consumption but by maintaining a high domestic savings rate that 
is used first to build up productive capacity at h~me and then to 
acquire assets abroad. Japan has yielded to American pressure by

raising the value of its currency but it will change its domestic 
economic policy only to the extent that is necessary to support 
the yen. 
One of the most potent reasons for expecting economic growth 
to remain sluggish is that it suits the policy objectives of the two 
leading countries. The constellation that seems to be emerging as 
a sequence to the Imperial Circle deserves to be described as the 
Golden Age of Capitalism. 
It is hard to believe that the golden days of capitalism could

come back again. After all, untrammeled free enterprise has pro- 
duced horrendous results in the past. Are we to repeat the same

Phase 1 : August 1985-December 1985 183 
experience again? Hopefully not. Perhaps we have learned some- 
thing from past mistake$. 
The fatal flaw of a free market system is its inherent instability. 
The belief that financial markets are self-regulating is simply 
false. Fortunately, Secretary Baker is aware of this fact and the 
administration has behn to exert active economic leadership 
since he moved to the Treasury. Certainly it is not laissez-faire

that has brought us to1 the threshhold of a new golden age of 
capitalism but a concerted economic policy designed to counter- 
act the excesses of a free market system. It remains to be seen how 
well we have learned our lessons. 
In any case, the benefits of the new golden age are very un- 
evenly spread. It is in the nature of capitalism that the gap be- 
tween winners and losers is rather wide. Large segments of the 
population, especially in the financial, technology, service, and

defense sectors, are flourishing. Others, especially in the older 
industries, agriculture, and the welfare sector, are suffering. For- 
tunes are made in financial deals and shareholders wield more 
power than at any timk in the last fifty years; at the same time, 
bankruptcies are also at a fifty-year high, in both size and num- 
bers. Debtor countries are wallowing in depression and a whole 
continent, Africa, is starving; at the same time China is converting

to a free market system with all possible speed and the Soviet 
Union is on the verge of moving in the same direction, albeit 
much more cautiously. 
Why the Reagan administration has been so successful in 
achieving its objectives is a fascinating question. To all intents 
and purposes the Democrats have been reduced to the party of 
losers, as manifested by the fact that it is the Democrats who push 
for protectionism in Congress, while President Reagan has an un-

questionable gift for making Americans feel like winners. But the 
improvement in sentiment has been achieved at the cost of con- 
siderable deterioration in the underlying reality, as manifested in 
our national indebtedness. 
Frankly, I have been surprised by the vitality of resurgent 
capitalism. I considered the Imperial Circle as a temporary ex- 
pedient that was bound to break down. Seeing it replaced by 
a new arrangement that can be described as the Golden Age of

Capitalism, I must acknowledge the adaptability of the system 
and its ability to survive. It remains to be seen whether policy- 
makers succeed in containing its weaknesses: the inherent in-

184 The Real-Time Experiment 
stability of financial markets and the iniquities caused by 
4 instability. 
P.S., MONDAY EVENING, DECEMBER 9,1985 
I have decided to move forward the date of switching from bonds 
to stocks. I am influenced partly by the prospect for "the 
Dec. 9,1985 
12/9/85 from 3216 12/9/85 from 1216 
DM 2.5345 - .9 S&P 500 204.25 - 3.7 
% 203.55 - .7 U.S. T-Bonds 8218/32 - 1.6 
E 1.4575 + 1.0 Eurodollar 91.87 - .5

E 1.4575 + 1.0 Eurodollar 91.87 - .5 
Gold 316.20 - 1.9 Crude Oil 27.51 - 4.3 
Japanese Bonds 97.00 - 2.2 
QUANTUM FUND EQUITY $890,000,000 
Net Asset Value Per Share $5,998 
Change from 12/6/85 + 2.7% 
Change from 8/6/85 + 37.0% 
Net Net 
(21 PI 
Positions (1) Long Short 1216 Exposure (6) Long Short 1216 
Stocks DM-related 693 - 36 
US Stocks 739 (66) +21 Japansse Yen 828 +2

US Stocks 739 (66) +21 Japansse Yen 828 +2 
US Index Pound Sterling (115) +4 
Futures 277 -91 US Dollar (516) +53 
Stocks 270 - 1 Currencies 45 + 12 
Bonds (3) 
US Gvt. 
Short 
Term (4) 90 
Long 
Term 717 + 56 
Japanese 
(5) 253 - 47 
Oil (157) -7 
Gold

Phase 1 : August 1985-December 1985 185 
bull market of a lifetime" that I have just articulated and partly 
by more practical considerations. A cut in the discount rate may 
not follow immediately upon agreement on Gramm-Rudman. 
Markets are firm and the Federal Reserve is cautious. The statis- 
tics for December may lbok quite good, partly because the Christ- 
mas shopping season is crowded into fewer days and partly 
because investment orders may be placed before the end of the

year to beat the changes' in taxation. The next advance indicators 
may also look good because they include stock prices and money 
supply. In these circumstances, bonds may be vulnerable and 
stocks may offer better prospects on the upside. The thesis I have 
just formulated is beginning to enter investors' ccneci~usnscses, 
yet caution is still prevalent. The year's end is seasonally a strong 
period: we could have some fireworks in the next four to five 
weeks.

FUND'S NET ASSET VALUE PER SHARE 
RELATIVE TO MARKETS 
Phase One: 8/19 to 12/8 1985 
40% 
35% 
30% 
25% 
20% 
15% 
10% 
5% 
0% 
-5% 
-10% 
Aug19 Sep2 Scp 16 Scp 30 Oct 14 Oct 28 Nov 11 Nov 25 
FUND'S PROFITS AND LOSSES 
Aug19 Sep 2 Sep 16 Scp 30 Oct 14 Oct 28 Nov 11 Nov 25 
Notes: 
(1) All prices are calculated as percent change over the first day shown. 
(2) EAFE is Morgan Stanley's Capital International Index in U.S. dollars for European. Australian, 
and Par Eastern stock markets.

and Par Eastern stock markets. 
(31 The Oil and the Government Bond prices are the closing prices of the ncamst futures contracts. 
(4) Currency profits and losses include only forward and futures contracts. P&L on foreign stocks 
includes the currency gain or loss on the positions.

CURRENCY PRICES 
Phase One: 8/19 to 12/8 1985 CURRENCY PRICES 
NET CURRENCY EXPOSURE 
(Line represents fund's equity) 
2.0 
. '1.8 
,111,1111,111 1111 
Aug 16 Aug 30 Sep 13 Sep27 Oct 11 Oct25 Nov 8 Nov 22 Dec6 
Deutsche Mark Yen 0 Pound *ling 
Fish Other 0 US. Dollar 
Notes: 
(1) Prices in U.S. dollars shown as percent change over the first day shown. New York closing 
prices are used.

prices are used. 
(2) Net currency exposure includes stock, bonds, futures, forwards, cash, and margins, and equals 
the total equity of the fund. A short position in U.S. dollars indicates the amount by which the 
currency exposure exceeds the equity of the fund. 
(31 Currency exposure shown as of end of week.

U.S. STOCK MARKET 
U.S. STOCK MARKET POSITIONS 
1.4 1 
I ____".' f""""'. Auk 19 & 2 Sep 16 30 O& 14 0g28 Nov 11 Nov 25 
U.S. Stocks B U.S. Stock Market Index Futures

Note: 
(1) Total U.S. stock market profits and losses include stock positions and index futures. 
&

FOREIGN STOCK MARKETS 
- European Stock Markets Index (in U.S. dollars) - Japancse Stock Market Index (in U.S: dollars) 
FOREIGN STOCK POSITIONS 
280, 
Continental Eumpean .">3 Japanese - British B Fih Far Eastern

FOREIGN STOCKS P/L 
Notes: 
(I) Total foreign stock market profits and losses include foreign exchange gains or losses on 
foreign stock positions. 
(2) Far Eastern positions include Hong Kong, Korea. Taiwan. Australia. and ~hgPfand.

-10% +",-", 
Aug 19 Sci COMMODITY PRICES 
COMMODITY POSITIONS 
80, I 
-220 ............................................ 
Aug19 Sep2 Sep16 Sep30 01x14 Oa28 Nov11 Nov2.5 
Oil Gold

FIXED INCOME SECURITIES 
40% 
35% 
30% 
25% 
20% 
15% 
10% 
5% 
0% 
-5% 
-10% 
-15% 
~u*lB !h$2 sep16 SO; 30 Od 14 02 28 N& 11 NO; 25 - U.S. Treasury Bill Futurea - U.S. Government Bond Futures - Jappme Government Bond Futurea 
FIXED INCOME SECURITIES POSITION 
1.8 -, I 
-0.2J, , , , , , , , , , , , , , , , , J 
Aug16 Aug30 Sep 13 Sep27 Oct 11 Oct 25 Nov8 Nov22 Dm6 
US Short Term Bonds U.S. Long Term Bonds 
Japanese Long Term Bonds

1 FDCED INCOME SECURITIES P&L 
- U.S. Short Term Bonds - U.S. Long Tcrm Bonds 
-"- ~ *.... Japancsc Long Tcrm Bonds 
Notcs: 
(1) U.S. Short Tcrm Bond positions and P&L include Treasury Bills. Trcasury Bill and Eurodollar 
Futurcs, and Trcasury Notcs up to two years to maturity. ,ia 
[2) All U.S. Govcrnmcnt Bonds arc reduced to a common dcnominator of 30-ycnr Govcrnmcnt 
Bonds. The basis of thc convcrsion is the cffcct on price of a givcn change in yicld. For instancc.

SlOO million in facc valuc of 4-ycar Treasury Notcs arc cquivalcnt to $28.5 million in markct 
valuc of 30-ycar Governmcnt Bonds. 
(3) Japancsc Govcrnmcnt Bond Futurcs havc considcrably lcss volatility than U.S. Govcrnmcnt 
Bonds. For instance, as of June 30, 1986. SlOO million in facc vnluc of japancsc Govcrnmcnt 
Bonds had the same volatility as roughly $66.2 million in 30-ycar U.S. Covcrnmcnt Bonds. We 
havc not adjusted for this diffcrcncc. 
(4) Positions shown as of end of wcck.

CONTROL PERIOD: 
JANUARY 1986-JULY 1986* 
SATURDAY, JANUARY 1 1,1986 t 
The stock and bond markets suffered a nasty break and I have 
been caught badly. I had taken on my maximum exposure in the 
stock market at the time of the December futures expiration- 
which corresponded with a temporary market peak-and did not 
dispose of my bond positions. As a consequence, I was fully ex- 
posed in both bonds and stocks at the time of the break. I was

toying with the idea of cutting my bond position in half and in 
fact sold about $100 million when the market dropped and I did 
not feel inclined to follow it down. Subsequently, I bought back 
prematurely the bonds I had sold. Only in currencies and in Eu- 
ropean stocks did 3 trade correcily. I eliminated my excess curren- 
cies at a moment of temporary strength so that I now have only 
my equity invested in foreign currencies-with a short position

in sterling against the DM-but no leverage. I also sold into 
strength in foreign stock markets so that my overall exposure 
remained stable despite the rise in prices. 
As usual, the break was caused by a combination of factors. The 
* This chapter is included mainly for its documentary value. It becomes quite 
repetitive. Readers not particularly interested in my macro-manipulations are 
advised to turn to p. 236. 
t Charts showing the posture and performance of Quantum Fund from Dec. 9,

1985, to Mar. 31, 1986, follow p. 207. The key for the parenthetical note refer- 
ences (1) through (6) in the diary-entry tables can be found on p. 147.

Control Period: January 1986-July 1986 197 
, Jan. 10,1986 
Closing % Change Closing O/o Change 
1110186 from 1219 1110186 from 1219 
DM 2.4675 +'2.6 S&P 500 205.96 + .8 
% 202.45 t+ .5 U.S. T-Bonds 83%~ + .8 
£ 1.4880 f 2.1 Eurodollar 91.85 0 
Gold 341.70 5 8.1 Crude Oil 25.79 - 6.3 
Japanese Bonds 98.55 + 1.6 
QUANTUM FUND EQUITY $942,000,000 
Net Asset Value Per Share $6,350 
Change from 12/9/85 + 5.9% 
Change frbm 8/16/85 +45.0% 
Net Net

Net Net 
(2) (2) 
Positions (1) Long ~dort 1219 Exposure (6) Long Short 1219 
Stocks DM-related 609 - 84 
US Stacks 1,011 (65) +273 JapaneseYen 612 - 216 
US Index Pound Sterling (278) -163 
Futures 717 +440 US Dollar (1) +515 
Stocks 318 + 48 Currencies 2 1 - 24 
Bonds (3) 4 us Gvt. 
Short 
Term (4) - 90 
Long 
Term 958 + 241 
Japanese 
(5) 259 +6 
Oil (224) -67 
Gold

(5) 259 +6 
Gold 
most important was a strong employment report that convinced 
the market that no discount rate cut is to be expected. The mea- 
sures taken against Libya also had an unsettling effect-there 
were various unconfirmed rumors about Arab selling of stocks, 
bonds, and dollars. I used one of these rumors to unload my 
currencies. The stock market may also have been affected by the

198 The Real-Time Experiment 
imposition of margin requirements on junk bonds. On Friday 
afternoon, two days after the initial break, the bond market broke 
through an important resistance point, 91/2% yield on 30-year 
bonds, amid concern about the constitutionality of Gramm- 
Rudman. 
What made the market vulnerable to these developments was 
the euphoria that prevailed at the time they occurred. Unfortu- 
nately, I was also caught up in it. That is why the break found me

fully exposed. I regard the current episode as a typical correction 
in a bull market. Its violence-a 5% drop in index futures in a 
couple of hours-foreshadows what is yet to come if and when 
the bull market becomes more extended. 
Typically, stock market booms survive a number of tests so that 
the market comes to be considered invulnerable and only then is 
it ripe for the bust. We are very far from that point yet. Sentiment

is still quite cautious. All that has happened is that the market 
has been disappointed in its expectation of any imminent dis- 
count rate cut. The short end of the bond market has already 
corrected-Eurodollar futures dropped by almost half a point; the 
long end may overreact, but, if so, I expect it to swing back again 
soon. As before, my position is predicated on the belief that the 
economy has no real momentum. The Federal Reserve may not

lower the discount rate, but it has no reason to allow the federal 
funds rate to trade up from the present level either. Equally, I 
consider the constitutional challenge to Gramm-Rudman imma- 
terial-the process will be working by the time the issue is de- 
cided. If this view is wrong, I shall have to revise my position at 
a considerable loss. Until then, I intend to hang in there. I expect 
the maximum pressure in the bond market to be felt tomorrow: it

remains to be seen how much damage will be done. The stock 
market ought to do better than the bond market from here on. 
The trouble is that not having sold I cannot buy now. All I can 
do is sit out this round and hope that the situation does not get 
out of hand. My cash reserves ought to be sufficient to see me 
through, but one can never be sure. The decline depletes my cash 
reserves and leaves me more exposed than I was before the break.

Since I expect the break to be temporary there is no point in 
raising cash now. By the same token, it would be totally unsound 
to reduce my cash reserve any further.

Control Period: January 1986-July 1986 199 
P.S., WEDNESDAY, JANUARY 15,1986 
The Group of Five are meeting this weekend. I know what I would 
do in their place: I would lower interest rates on a multilateral 
basis. This would shbw that the authorities are cooperating and 
are in command of tlie situation. It would help maintain stability 
in the foreign exchange market; without it, it may be difficult 
to prevent a tempordry rise in the dollar. The ground has been

thoroughly prepared: the Gramm-Rudman process is in opera- 
tion and the use of junk bonds has been curbed. Japan is wait- 
ing for the United States to take the lead in lowering interest 
rates. It is true that 1M"ras exceeded the target range =d the 
economy has probably grown about 3%% in the fourth quarter 
of 1985. If it is business as usual, there is no need to move; but 
if the authorities feel the need to maintain the initiative, this is

the time to do it. Lowering the discount rate would mean 
publicly abandoning monetarism; but the bond market would 
accept the move because it is done in concert with other nations, 
exchange rates are stable, and Volcker's reputation as a sound 
money man is unscathed. The question is, does he want to do 
it? 
I am reluctant to believe that the authorities will do what I 
would like them to. Nevertheless, I am willing to bet on it at this

time, subject to the constraints of my already exposed position. 
That means that I will buy some Eurodollar futurcht; that are rela- 
tively riskless. The only risk is that I become even more exposed 
and must cut my exposure at the wrong time. I am willing to take 
the risk because, if the bet fails, I intend to cut back my exposure 
anyhow. After all, my thesis is that the authorities have taken the 
initiative; if they do not maintain it, what reason do I have to

maintain a leveraged position other than a reluctance to take a 
loss? There is a French military expression, reculer pour mieux 
sauter. I shall do the opposite: I shall advance in order to regroup. 
I shall relieve my present exposure, which I find unsustainable in 
the long run, by increasing it in the short run. 
TUESDAY MORNING, JANUARY 2 1,1986 
The Group of Five meeting did not produce any clear-cut results. 
One could hardly expect any dramatic announcements after all

200 The Real-Time Experiment 
Jan. 20,1986 
1/20185 from 1/10 1/20/85 from 1/10 
DM 2.4580 + .4 S&P 500 207.53 + .8 
V 202.45 0 U.S. T-Bonds 83lV32 + .5 
E 1.4125 - 5.1 Eurodollar 91.91 + .1 
Gold 354.10 + 3.6 Crude Oil 21.27 - 17.5 
Japanese Bonds 98.00 - .6 
QUANTUM FUND EQUITY $1,006,000,000 
Net Asset Value Per Share $6,775 
Change from 1/10/86 + 6.7% 
Change from 8/16/85 + 54.7% 
Net Net 
(2)

Net Net 
(2) 
Investment (2) 
from Net Currency from 
Positions (1) Long Short 1/10 Exposure (6) Long Short 1/10 
Stocks DM-related 559 - 50 
US Stocks 1,014 (73) -5 Japanese Yen 612 0 
US Index Pound Sterling (270) +8 
Futures 584 -133 US Dollar 105 + 106 
Stocks 314 - 4 Currencies 31 + 10 
Bonds (3) 
US Gvt. 
Short 
Term (4) 88 + 88 
Long Term 
1,026 + 68 
Japanese 
(5) 261 $2 
Oil (159) +65 
Gold

(5) 261 $2 
Gold 
the terse statement was less than enlightening. I am left to my 
own devices in conjecturing about what actually happened. 
I believe that the goal of reducing interest rates on a worldwide 
basis was recognized, but the two truly independent central 
banks, those of Germany and the United States, refused to make a 
commitment to concerted action. I suspect that the Federal Re-

Control Period: January 1986-July 1986 201 
serve has subtly moved to ease monetary policy even before the 
meeting-next ~hursda~~s figures should provide more conclu- 
sive evidence-but it wants the market response to determine 
when the discount rate should be cut and not a consortium of 
governments. Allowing the Group of Five to dictate U.S. mone- 
tary policy would conbtitute far too dangerous a precedent to be 
acceptable to a central bank that wants to preserve its indepen- 
I dence.

I dence. 
What is disturbing about the outcome is the implication of a 
possible rift between Baker and Volcker. In retrospect, the dissent 
between Volcker and the administration on the issue of imposing 
margin requirements on junk bonds assumes gr~qtsr sicnificance. 
Volcker seems to be worried that lowering interest rates too ag- 
gressively would merely fuel a stock market boom that could end 
in a crash-and I would be the last person to contradict him. The

fact that he is worriea about it makes the boom less likely to 
develop. In any case, the Group of Five has lost some momentum 
and that is a dangerous development. 
I felt it incumbent oh me to reduce the extra exposure I assumed 
prior to the meeting, but I decided to wait before executing my 
plan of deleveraging until the next set of Federal Reserve figures 
become available. Instead of selling the Eurodollar futures I 
bought, I sold some S&P 500 index futures because I considered

the stock market more. vulnerable. 
In the course of the day, the decline in energy prices accelerated 
until it turned into a veritable rout. By the end of the day, stocks, 
bonds, and currencies have all recouped the day's losses. This 
constitutes a major event. The long-awaited collapse of oil prices 
is finally happening. 
There is nothing to stop a free fall from developing except gov- 
ernment intervention; but governments intervene only in emer-

gencies. The suspicion of a disagreement between Volcker and 
Baker further weakens the chances of timely action. We are there- 
fore headed for a period of maximum risk for the banking system. 
What is going to happen to all the energy loans and the energy- 
dependent debtor nations? 
I am convinced that the situation is not going to be allowed to 
get out of hand because a remedy is readily available: an import 
tax on oil with special provisions for Mexico. But in order to

impose a tax, President Reagan would have to reverse himself; 
only an emergency would provide him with an excuse: therefore

202 The Real-Time Experiment 
the situation will have to deteriorate before the remedy is applied. 
It behooves me to deleverage as far as possible. The fall in oil 
prices has many positive implications for both stocks and bonds, 
but it would be inappropriate to speculate on them on a leveraged 
basis, especially as the initial response of the market is likely to 
be the same as my own. 
SATURDAY, FEBRUARY 22,1986 
I deleveraged too soon: I failed to take full advantage of a powerful

upsurge in both the stock and bond markets. I even got myself 
short bond futures temporarily when I Lewd ha? ;he lo~er court 
was going to rule against the constitutionality of Gramm-Rudman, 
but the decision was delayed a week and the collapse in oil prices 
outweighed everything else in importance so that I was forced to 
cover with a loss. In short, my trading was poor. Nevertheless, the 
fund did well, helped by our short positions in oil and the dollar.

Our stock selection has also been working for us. 
The fact is, I would feel uncomfortable to be too heavily ex- 
posed at the present time-that is probably why I traded poorly 
when I did have a leveraged position. I look at the decline in oil 
prices as a combination of two influences: an economic stimulus 
and a financial shock. The markets are reacting to the first influ- 
ence, while I am extremely sensitive to the second. 
We are approaching the moment of truth on the international

debt issue. With oil below $15, Mexico has a prospective debt 
service deficiency on the order of $10 billion. To make it up, a 
number of things have to happen. Mexico must tighten its belt 
further; the banks will have to take a hit; and the United States 
will have to fork out some money, in the form of either grants or 
price protection on Mexican oil. It can be done, but it will be a 
complex and delicate operation. The concessions made by the

banks will have to be extended to other debtor countries. Money 
center banks as a group are now in a position to absorb a signifi- 
cant cut in interest rates on loans to the less developed countries, 
but Bank of America, for one, is likely to be pushed over the 
brink. It will be bailed out, along the lines of Continental 
Illinois Bank, and depositors will be protected. Depositors may 
not even panic, but the stock market may. The strength of the

market, combined with the amount of credit involved in futures 
and options trading, makes the market extremely vulnerable to a

Control Period: January 1986-July 1986 203 
I Feb. 21,1986 
2/21/86 from 1/20 2/21/86 from 1/20 
DM 2.2960 +'6.6 S&P 500 224.62 + 8.2 
Y 182.20 + 30.0 U.S. T-Bonds 900%~ + 8.0 
E 1.4545 +#3.0 Eurodollar 92.10 + .2 
Gold 341.00 -'3.7 Crude Oil 13.53 - 36.4 
I Japanese Bonds 101.60 + 3.7 
QUANTUM FUND EQUITY $1,205,000,000 
Net Asset Value Per Share $8,122 
Change from 1/20/86 + 19.9% 
Change frotn 8/46/85 I- 35.5% 
Portfolio Structure (in millions of dollars)

, Net Net 
12) (2) 
lnvestment from Net Currency from 
Positions (1) Long Short 1/20 Exposure (6) Long Short 1/20 
Stocks DM-related 783 + 224 
US Stocks 1,064 (185) - 62 Japanese Yen 726 + 114 
US Index Pound Sterling (343) -73 
Futures (92) -676 US Dollaf 39 - 66 
Stocks 426 11 2 Currencies 81 + 50 
Bonds (3) 
US Gvt. 
Short 
Term (4) - 88 
Long 
Term 215 -811 
Japanese 
(5) - 261 
oil (55) + 104 
Gold

(5) - 261 
Gold 
sudden reverse. It was 5% in two hours in January; it may be 10% 
or 15% next time. I believe that the risk of a collapse has shifted 
from the banking system to the financial markets and I would feel 
very foolish if I got caught. My caution may cost me dearly, but it 
will also ensure my survival. 
When I heard that President de la Madrid of Mexico is going to

204 The Real-Time Experiment 
make a speech tonight, I sold some S&P futures and some dollars 
I short as an insurance policy over the weekend. 
THURSDAY, MARCH 27,1986 
I have made very few macro moves since I reduced my leverage 
at the end of January. In retrospect, I moved too soon because I 
missed the best part of the bond market rally. Obviously I under- 
estimated the bullish implications of the decline in oil prices. 
Frankly, I did not think that oil would be allowed to fall so far

without government intervention. There is nothing to stop oil 
from falling except government intsrvcntion, because the supply 
curve is inverted: the lower the price goes, the more oil has to be 
sold in order to meet the producing countries' requirements. 
Eventually, domestic producers will have to be protected. That 
was the reason I switched my short position from West-Texas to 
Brent contracts-a move that turned out to be expensive because 
I got caught in a short squeeze.

I got caught in a short squeeze. 
I can justify my decision to reduce leverage only on subjective 
grounds. Operating on leverage involves considerable strain and 
I have made enough money recently not to want to live with it. 
But missing an opportunity is also painful. Fortunately I did not 
miss the market: I merely failed to take maximum advantage of it. 
I remained largely inactive in currencies. The only thing I did 
was to build up the DM/£ cross position further. I recognized that

the nature of the currency markets was, once again, changing: the 
spirit of cooperation that emerged from the first Group of Five 
meeting was weakened in the second and the authorities were 
losing control over the market. The dollai -was moving faster and 
lower than the authorities desired. Both the Japanese and the 
Germans were getting worried. The American authorities were 
divided: Volcker shared their concern while the rest of the admin-

istration felt that the Japanese squirming was a welcome sign that 
the lower dollar was beginning to bite. The dollar was falling of 
its own momentum and it was not clear what caused the decline: 
the fall in oil prices must have had something to do with it. Part 
of the impact was nonrecurring-fewer dollars were needed to 
finance oil transactions-but the trend was pronounced enough 
to attract speculative positions. 
I kept my short position in the dollar intact not because I had

any great convictions but because I had no firm views and I felt

Control Period: January 1986-July 1986 205 
, Mar. 26,1986 
3/26/86 from 2/21 3/26/86 from 2/21 
DM 2.3305 -3.5 S&P 500 237.3 + 5.6 
Y 179.65 +?.4 U.S. T-Bonds 981J/3~ + 9.2 
E 1.475 + 3.4 Eurodollar 92.83 + .8 
Gold 344.40 fa.0 Crude Oil 12.02 - 11.2 
I Japanese Bonds 105.50 + 3.8 
QUANTUM FUND EQUITY $1,292,000,000 
Net Asset Value Per Share $8,703 
Change from 2/21/86 + 7.2% 
Change !ram 8!l6/85 + 98.7% 
Portfolio Structure (in millions of dollarsl 
Net Net

Net Net 
(21 (2) 
Positions (1 ) Long Short 2/21 Exposure (6) Long Short 2/21 
Stocks DM-related 1,108 + 325 
US Stocks 1,272 (I~o) + 223 Japanese Yen 492 - 234 
US Index Pound Sterling (389) -46 
Futures 124 + 216 US Dollar 81 + 42 
Stocks 536 + 110 Currencies 63 - 18 
Bonds (3) a US Gvt. 
Short 
Term (4) 
Long 
Term 326 + PI1 
Japanese 
(5) 
Oil (28) +27 
Gold

Japanese 
(5) 
Gold 
that my chances of making money by trading currencies did not 
justify the trouble and aggravation. Holding the position was 
more comfortable than changing it and my lack of convictions put 
me in a good position to reassess the situation when necessary. 
Then came Preston Martin's resignation and the behind-the- 
scenes struggle over interest rates came out into the open. The

206 The Real-Time Experiment 
market responded with a sharp rally in the dollar. Sterling also 
rallied against the DM and I was facing a big loss in currencies- 
the first since the inception of dirty floating. It forced me to reas- 
sess the macroeconomic situation. 
What I find is continued economic stagnation. Elements of 
strength and weakness are well balanced. The strength comes 
mainly from lower interest rates and the optimism generated by

improving profit margins; housing, restocking, new business for- 
mation, increased employment in the service sector are also pos- 
itive influences. The major source of weakness is in the oil 
industry. Oil is a major component in capital spending and prob- 
ably equals in importance the automobile industry. Other forms 
of capital spending are also weak, although they can be expected 
to improve with the passage of time. Another source of weakness,

the reduced budget deficit, has not yet had time to make its impact 
felt. The savings rate seems to be improving, keeping consumer 
spending in check. Investors are responding to lower interest 
rates by moving into stocks and long-term bonds. All this is very 
bullish, both for bonds and stocks. 
In view of the soft economy, I see no reason to cut my short 
position in the dollar. Rather, I take the current strength of the 
dollar as a reason to expect interest rates to fall further. Accord-

ingly, I have decided to reestablish my long position in bonds. To 
buy bonds on a 71/2% yield basis when I sold them with a 9 to 
9%% yield is not an easy decision to make; but the logic of the 
situation forces me into it. It is inconsistent to be short dollars 
without being long bonds-and I think it would be wrong to buy 
dollars now. What about the leverage involved? After all, it was 
the reluctance to carry leverage that induced me to reduce my

exposure in the first place. Undoubtedly, it increases the tension, 
but by the same token it relieves the tension that was inherent in 
being short dollars without being long bonds. I shall have to cope 
by being more alert. 
What are the prospects for a significant setback in both stocks 
and bonds? When I look at the internal dynamism of the market, 
I find that the boom is far too young and vigorous to collapse of 
its own weight. Investors are still very cautious, including myself.

Stocks are just on the verge of becoming too expensive for lever- 
aged buyouts, and the real rate of interest is still too high, given 
the collapse in oil prices. Either the dollar or interest rates have 
to decline, or both. Since the dollar has stabilized, it is interest 
rates that have to move further.

Control Period: January 1986-July 1986 207 
On internal grounds alone, the boom has a long way to go: stock 
prices could double or more before they become vulnerable. Some 
of the smaller stock markets are far more exposed. Italy is a case 
in point. If and when we have a crash it ought to affect Italy before 
it affects the United States. 
At present, the only hanger is an external shock. Its potential 
origin is clearly visible; oil prices are set on a collision course.

Oil will continue falling until it sets off some catastrophic event 
that will arrest or reverse the trend. We may distinguish between 
the two kinds of cathartic events: military and financial. 
Militarylpolitical developments are notoriously difficult to an- 
ticipate. Tensions in the Middle Eaet are rising. We have had a 
near-revolution in Egypt; the Iran-Iraq war shows signs of escalat- 
ing; the incursion of the American fleet into the Bay of Sidra

passed off without serious repercussions, but we can expect other 
incidents. Since they cannot be anticipated, all I can do is stay 
alert. A mild degree of leverage serves to heighten awareness. 
The financial repercussions of lower oil prices are much more 
obvious. Mexico, in p&ticular, is an event waiting to happen. 
Will it be an orderly bailout or a confrontation? Mexico has 
backed down from asking for interest rate concessions. The like-

lihood is that some kind of oil-denominated security will be of- 
fered to disguise the concession that Mexico needs and to prevent 
it from spreading to other debtor countries. 
What is more difficult to fathom is the reaction &the markets. 
An orderly settlement would reinforce the bullish trend, but 
doubts about an orderly settlement would test the market. At 
present, the odds are that the market will pass the test, but it 
would be best not to be exposed while the issus is decided.

SUNDAY, APRIL 6,1986 * 
Last Tuesday, I shorted the S&P futures in an amount equal to my 
long position in bonds. This has effectively eliminated my lever- 
aged exposure on the long side. I am now looking for the right 
entry point for increasing my short position, so as to reduce my 
net exposure even further. 
Vice-President Bush has announced his intention to discuss oil 
* Charts showing the posture and performance of Quantum Fund from Mar. 31,

1986, to July 21,1986, follow p. 225. The key to the parenthetical note references 
(1) through (6) in the diary-entry tables can be found on p. 147.

RELATIVE TO MARKET 
Control Period: 12/9 1985 to 7/20 1986 
(Breakdown by major positions) 
- U.S. Stocks - Foreign Stocks -- Crude Oil - Currencies Bonds 
Notes: 
(2) EAFE is Morgan Stanley's Capital International Index in U.S. dollars for European. Australian. 
and Far Eastern stock markets.

and Far Eastern stock markets. 
(31 The Oil and the Government Bond prices are the closing prices of the nearest futures contracts. 

Dec 9 Dcc 23 Jan 6 Jan 20 Fob 3 Feb 17 Mar 3 Mar 17 - Dcutsche Mark , ---- Yon --- Pound Storling - Swiss Franc 
YET CURRENCY EXPOSURE 
2.0 , I 
IIIIIII I I I I"'" 1 
Dec 20 Jan 3 Jan 17 Jan3l Feb 14 Feb28 Mar 14 Mar28 
biTSSIJ Deutxhe Mark Yen Pound Sterling 
cz3 Fih Other 0 U.S. Dollar 
Notes: 

(2) Net currency exposure includes stock, bonds, futures, forwards. cash. and margins, and equals 
the total equity of the fund. A short position in U.S. dollam indicates the amount by which the 
(3) Currency exposure shown as of end of week.

U.S. Stocks III U.S. Stock Market Index Futures

U.S. STOCK MARKET PROFITS AND LOSSES 
&9 DL 23 ]&6 jai 20 Fib 3 Fcb 17 Mar3 Mar 17 - U.S. Stocks - U.S. Stock Market index Futures 
Note: 
(1) Total U.S. stock market profits ind losses include stock positions and index futurcs. 
4-

Dec 9 Dec 23 Jan 6 Jan 20 Feb 3 Feb 17 M& 3 M& 17 - European Stock Markets Index (in U.S. dollars) - Japanese Stock Market Index (in U.S. dollars) 
700 
1 
""""~r-I1.Ir,.I.,I,..I.,,.,1~,,,,.,,.,,,,..,,..,,rI,..,,,,,, 
Dec9 Dee23 Jan6 Jan20 Feb 3 Feb 17 Mar 3 Mar 17 
Continental Eupopean Japanese I Bntish 
Finnish B Far Eastern

FOREIGN STOCK MARKET PRICES 
80% 1 I I I I I I I 1 
&c9 Dec,23 Jan6 Jan 20 Feb 3 Feb 17 ML~ M& 17 - Eumpcan Stock Markets Index (in U.S. dollars) - Japahese Stock Market index (in U.S. dollars) 
600 i 
-1~)+rmr,~~~,~~..~....~,.~,%~...~,,..,,.,,,,~~ 
Dec 9 Dec 23 Jan 6 Jan 20 Feb 3 Feb 17 Mar 3 Mar 17 
B Continental European Japanese Bntish 
Flnmsh B Far Eastern

I& 9 Dec 23 Jan6 Jan 20 Feb 3 Feb 17 M& 3 M& 17 - Eu~pean Stock Markets Index (in U.S. dollars) - Japanese Stock Market Index (in U.S. dollars) 
700 
-l~~~~~~,.~,,,~,,~~~~~,~,.~..,~~~.~~.,~,.,,.,,~,,,~,,,,,,,.,,~.,~.,~~.,,,,,, 
Dec 9 Dec 23 Jan6 Jan 20 Feb 3 Feb 17 Mar 3 Mar 17 
Continental Eumpean Japanese Brihsh 
Fmh Far Eastern

D& 9 DA 23 Jan 6 Jan 20 Fob 3 Feb 17 Mar 3 Mar 17 - Continental ~urd~ean ---- Japanese - . British - Finnish Far Eastern 
Notes: 
(1) Total foreign stock market profits and losses include foreign exchange gains or losses on 
(2) Far Eastern positions include Hong Kong, Korea, Taiwan. Australia, and Th&and.

COMMODITY PRICES 
70% 
60% ! I I I I ! I 
-70% 
Dec9 Dec 23 Jan 6 Jan 20 Feb 3 Feb 17 Mar 3 Mar 17 - Oil ---- Gold 
Dec 9 DM: 23 Jan6 Jan 20 Fcb 3 Fcb 17 Mar 3 Mar 17 
Oil - Gold

, 
COMMODITY PROFITS AND LOSSES 
- oil - Cold - Total Commodity P&L

70% 
60% 
50% 
40% 
30% 
20% 
19% 
0% 
-10% 
-20% 
I - -I----.--.- D&Q ~A23 ~&6 ~i20 ~eb3 ~ek17 Mar3 Mar17 - U.S. Treasury Bill Futures - U.S. Covernment Bond Futures 
. . . . . . . . . . . . . . . Japanese Government Bond Futures 
1.6 
-0.6 fd 
-0.8 
-1.0 , , , , , , , , , , , , , I I 
Dec20 Jan 3 Jan 17 Jan31 Feb 14 Feb28 Mar14 Mar28 
U.S. Short Term Bonds 0 U.S. Long Term Bonds

U.S. Short Term Bonds 0 U.S. Long Term Bonds 

EIXED INCOME SECURITIES P&L 
k9 Dee23 Jan6 Jan20 Feb3 Fob17 Mar3 Mar17 - U.S. Short Term Bonds - U.S. Long Term Bonds 
. . . . .. . . . . ... . . Japanese Long ~erm Bonds 
Notes: 
(1) U.S. Short Term Bond positions and P&L include Treasury Bills. Treasury Bill and Eurodollar 
Futures, and Treasury Notes up to two years to maturity. 
(2) All U.S. Government Bonds are reduced to a common denominator of Government

Bonds. The basis of the conversion is the effect on price of a given change in yield. For instance. 
$100 million in face value of &year Treasury Notes are equivalent to $28.5 million in market 
value of 30-year Government Bonds. 
(3) Japanese Government Bond Futures have considerably less volatility than U.S. Government 
Bonds. For instance, as rf June 30,1986. $100 million in face value of Japanese Governmen!

Bonds had the same volatility as roughly $66.2 million in 3Cyear U.S. Government Bonds. We 
have not adjusted for this differcncc. 
(4) Positions shown as of end of week.

218 The Real-Time Experiment 
prices on his visit to Saudi Arabia. This has elicited a negative 
reaction from the administration, engineered no doubt by his old 
enemy Donald Regan. The net effect is to reduce the chances of 
an import tax on oil. There is always the possibility that OPEC 
will get together and reduce output but I rate the chances rather 
low. Now that the structure has fallen apart, it will need a cathar- 
tic event to put a new structure in place. Having taken the plunge,

Apr. 4,1986 
4/4/86 from 3/26 4/4/86 from 3/26 
Dkl 2.3955 - 2.8 S&P 500 228.69 - 3.6 
Y 180.42 - .4 U.S. T-Bonds 1001%2 + 1.9 
£ 1.4500 - 1.7 Eurodollar 93.13 + .3 
Gold 335.40 - 2.6 Crude Oil 12.74 + 6.0 
Japanese Bonds 104.15 - 1.3 
QUANTUM FUND EQUITY $1,251,000,000 
Net Asset Value Per Share $8,421 
Change from 3/26/86 - 32% 
Change from 8/16/85 + 92.3% 
Net Net 
(2) (2)

Net Net 
(2) (2) 
Positions (1) Long Short 3/26 Exposure (6) Long Short 3/26 
Stocks DM-related 1,094 - 14 
US Stocks 1,171 (167) -98 Japanese Yen 475 - 18 
US index Pound Sterling (380) +9 
Futures (572) -696 US Dollar 63 - 18 
Stocks 499 - 37 Currencies 50 - 13 
Bonds (3) 
US Gvt. 
Short 
Term (4) 
Long 
Term 652 + 326 
Japanese 
(5) 
Oil (29) -1 
Gold

Control Period: January 1986-July 1986 219 
why should Saudi Arabia take the risk of a makeshift solution? 
The United States is the high-cost producer; by staying the course, 
U.S. production can be permanently reduced. It was to be ex- 
pected that U.S. production would be protected, but recent events 
reduced that possibility. I expect the pressure on oil prices to 
continue. , I 
Declining oil prices are bullish until they turn bearish. Strange

as it may seem, most fdrecasts have failed to take into account the 
reduction in U.S. oil production. Instead of stimulating the econ- 
omy, the initial impact is negative. Altogether, the economy 
seems weaker than prevailing expectations. That is why I am un- 
willing to reduce my short position in the dollar. In fact, I intend 
to increase it by covering my short position in sterling. I seem to 
have overstayed my welcome. The interest rate differential is at-

tracting funds to sterling and I do not have a strong enough case 
to fight the trend. 
I am happy with the cross position I have established, long 
bondslshort S&P futures, but I am less happy with my net long 
position in stocks. I am looking for an opportunity to reduce the 
exposure. I do not expect a collapse, but a correction of undeter- 
mined magnitude. The right entry point will be when oil prices 
start declining again. The initial response ought to be positive, for

both bonds and stocks. It may come only after the April 15 meet- 
ing of OPEC. 
d-Q. 
WEDNESDAY, APRIL 9,1986 
The market flip-flopped in the last two days and so did I. On 
Monday, oil rallied sharply, arid bonds, stocks, and currencies 
sold off; on Tuesday, all these markets reversed themselves. The 
move on Monday hurt me on all fronts. I discovered how sensitive 
my portfolio was to oil prices; I also discovered that there was

more leverage in it than I thought. I had neglected my DM/£ cross 
position, which turned against me with a vengeance. To quantify 
it, I dropped a cool $100 million from the onset of the correction, 
despite my S&P futures hedge, which saved me some $20 million. 
On Monday, I cut both my DM/£ exposure and my short posi- 
tion in oil in half and covered 40% of my S&P short; on Tuesday, 
I covered the rest of my S&P short and did some bargain hunting

in stocks. The net effect is that I increased my exposure in stocks 
and bonds while I reduced it in currencies and oil. 
Based on information received Monday morning, I modified my

220 The Real-Time Experiment 
Apr. 8,1986 
Closing % Change Closing % Change - 
4/8/86 from 4/4 4/8/86 from 414 
DM 2.3325 + 2.6 s&P 500 242.38 + 6.0 
V 179.80 + .3 U.S. T-Bonds 10131/32 + 1.6 
£ 1.4650 +1.0 Eurodollar 93.30 + .2 
Gold 340.00 + 1.4 Crude Oil 12.47 - 2.1 
I Japanese Bonds 103.58 - .5 
QUANTUM FUND EQUITY $1,290,000,000 
Net Asset Value Per Share $8,684 
Change from 4/4/86 + 3.1% 
Change from 8/16/85 +98 3% 
I Portfolio Structure (in millions of dollars) 
Net Net 

Net Net 
(21 
Positions (1) Long Short 414 Exposure (6) Long Short 414 
Stocks DM-related 810 - 284 
US Stocks 1,231 (169) +58 Japanese Yen 504 + 30 
US Index Pound Sterling (177) +203 
Futures +572 US Dollar 153 + 90 
Stocks 578 + 79 Currencies 57 +7 
Bonds (3) 
US Gvt. 
Short 
Term (4) 
Long 
Term 656 +4 
Japanese 
(5) 
Oil (12) $17 
Gold 
short-term outlook on oil. Two positives came to my attention:

the likelihood that motorists would use more gasoline this sum- 
mer, especially with the impact that terrorism is making on for- 
eign air travel, and the probability that oil companies will shut 
down their North Sea oil production for extended maintenance 
because they can make almost as much money on their net-back

Control Period: January 1986-July 1986 221 
agreements with Saudi Arabia. There is therefore room for a trad- 
ing rally prior to the OPEC meeting next week. By buying Brent, I 
am setting up a cross position of Brent vs. WTI (domestic oil). 
With the prospect of import duties receding, this makes sense to 
me. 
I have no particular Giews on sterling. It is now reacting to the 
favorable interest rate differential, rather than to the price of oil.

As it strengthens, the interest rate differential will be reduced 
because the government cannot allow sterling to appreciate. This 
limits the upside potential for sterling, but that is not a good 
reason for staying short, The plain fact is, I neglected the position 
and failed to take my profit; now I must disengage myself without 
a profit. I liquidated half my position immediately and hoped to 
do the rest at more favorable prices. The U.K. lending rate was in

fact cut by 1/2% on Tuesday, touching off the rally in U.S. stocks 
and bonds. 
The stock and bond markets reacted negatively to the rise in oil 
prices, but it has made me more bullish. The real danger, in my 
view, is a further fall. I'regard the decline as a healthy correction 
in a bull market and a buying opportunity that I decided to exploit 
within the limits of prudence. I am now fully extended. 
The ploy seems to be working. The underlying weakness in the

economy is now gaining recognition and there is a meeting of the 
minds on further coordinated interest rate reductions. The expec- 
tation is strong enough to overshadow concern abut Libya al- 
though U.S. retaliation is almost inevitable. 
After a period of increased activity I hope to sit back again. I 
want to reduce the leverage, but not too soon. I should like to let 
the profits run for a wkile. 
WEDNESDAY, MAY 21,1986 
I remained rather inactive in April and what little I did served to

reduce my exposure. I sold a small amount of stocks, a larger 
amount of currencies, and almost my entire bond position. At the 
beginning of May, I became more active. I made a foray into bonds 
at the time of the quarterly refunding, which looked promising at 
first but turned very sour afterward. I took my loss early, but as 
the bonds continued to fall, I began to accumulate a position 
again. On the other hand, I took a significant short position in S&P

futures, so that I now have a slight negative exposure in stocks

122 The Real-Time Experiment 
Mav 20.1986 
Closing O/O Change 
5120186 from 418 Closing O/O Change 
5120186 from 418 
DM 2.3100 + 1.0 S&P 500 236.11 - 2.6 
Y 168.18 + 6.5 U.S. T-Bonds 9605/32 - 5.7 
£ 1.5215 + 3.9 Eurodollar 92.96 - .4 
Gold 339.00 - .3 Crude Oil 16.04 + 28.6 
Japanese Bonds 102.42 - 1.1 
QUANTUM FUND EQUITY $1,367,000,000 
Net Asset Value Per Share $9,202 
Change from 4/8/86 + 6.0°/~ 
Change from 8/16/85 + 1"l.2% 
Net Net

Net Net 
(2) (2) 
Positions [I) Long Short 418 Exposure (6) Long Short 418 
Stocks DM-related 485 - 325 
US Stocks 1,208 (58) 88 Japanese Yen 159 - 345 
US Index Pound Sterling (21) +I56 
Futures (770) - 770 US Dollar 744 + 591 
Stocks 573 - 5 Currencies 148 + 91 
Bonds (3) 
US Gvt. 
Short 
Term (4) 
Long 
Term 313 - 343 
Japanese 
(5) 
Oil (75) -63 
Gold (29) -29

(5) 
Gold (29) -29 
that more or less balances my positive exposure in bonds. I have 
also built up a short position in oil in a rising market, which is 
currently showing a loss. Furthermore, I am in the process of 
building up a short position in gold. All told, my trading activity 
cost me some money but it has put me in a position in which I 
feel comfortable. My aim is to limit my losses rather than to make 
a lot of money.

Control Period: January 1986-July 1986 223 
The outlook for the dollar is quite uncertain; a half-and-half 
position seems safest. The decline of the dollar has gone further 
than the authorities intended; there is also a greater degree of 
dissent among the major powers than I like to see. Moreover, the 
Federal Reserve, which is still laboring under the influence of 
monetarism, expects the economy to pick up in the second half.

All this is serving to rkduce the likelihood of further interest rate 
reductions. I 
MONDAY, JULY 21,1986: END OF THE CONTROL PERIOD 
1 have made my first major strategic change since the end of the 
real-time experiment. Without abandoning the thesis that we are 
in "the bull market of a lifetime," I have adopted a new thesis, 
namely, that the bull market may be cut short by a deflationary 
spiral engendered by the collapse of oil prices. The second hy-

pothesis will be tested in the next few months; if we survive the 
test, the case for "the bull market of a lifetime" will remain intact 
-indeed, its lifespan will be extended. Thus, for the near future 
I shall operate with two contradictory theses. This is a suitable 
subject for another real-time experiment; therefore, I shall wind 
up the control period at this point. 
I have done very little outside my equity portfolio since the last

report. My major move was in currencies and it was a costly one. 
First, I covered my entire short position in the dollar and then I 
reestablished a fully hedged position at lower Izvels. My first 
move was triggered by some signs that the U.S. economy may be 
strengthening: the advance indicators and the purchasing agents' 
report for May were deceptively strong. I had no firm t~iews an 
the currencies, and I did not feel like losing my accumulated

profits. I figured that, with a dollar-denominated fund, being in 
dollars can just as easily be called neutral as being half in and 
half out. Needless to say, I covered close to the top of the trading 
range. 
The fact is that it is very difficult to maintain a "neutral" posi- 
tion in a fluctuating currency market. Market participants have an 
existential choice to make and if they have no clear views they 
are bound to make the wrong choice. One can, of course, neutral-

ize one's position by buying currency options, but, in that case, 
one has to pay a measurable cost for neutrality. In the last few 
months of the control period I was not as much in touch with the 
markets as during the period of the experiment itself. I was work-

224 The Real-Time Experiment 
July 21,1986 
7/21/86 from 5/20 7/21/86 from 5/20 
DM 2.1195 + 8.2 S&P 500 236.22 0 
Y 179.65 - 6.8 U.S. T-Bonds 9931/32 + 4.0 
£ 1.4995 - 1.4 Eurodollar 93.64 + .7 
Gold 355.00 + 4.7 Crude Oil 13.09 - 18.4 
Japanese Bonds 103.32 + .9 
QUANTUM FUND EQUITY $1,478,000,000 
Net Asset Value Per Share $9,885 
Change from 5/20/86 + 7.4% 
Change from 8/16/85 -t 125.7% 
Net Net 

Net Net 
(21 12) 
Positions (1) Long Short 5/20 Exposure (6) Long Short 5/20 
Stocks DM-related 795 + 310 
US Stocks 1,089 (86) - 147 Japanese Yen 549 + 390 
US Index Pound Sterling (25) -4 
Futures (950) - 180 US Dollar 159 - 585 
Stocks 604 + 31 Currencies 202 + 54 
Bonds (3) 
US Gvt. 
1 Short 
Term (4) 29 + 29 
Long 
Term (570j -883 
Japanese 
(5) 1,334 + 1,334 
Oil (43) +32 
Gold (34) -5

Gold (34) -5 
ing on the more theoretical sections of this book and spent May 
and June in Europe. The macro moves I made during the control 
period have reflected this: they added very little to the overall 
results; if I take the currency trading into account, the net contri- 
bution was negative. As the following table indicates, the bulk of 
the profits came from the equity side.

Control Period: January 1986-July 1986 225 
To discuss the composition of the equity portfolio in detail 
would take us too far'afield, but it is worth pointing out that at 
least two major investment themes, one relating to Finnish shares 
and the other to Japanese railroad and real estate shares, are 
closely related to the concept of "the bull market of a lifetime." 
The real estate concept also extends to Hong Kong. Taken to- 
gether, these investments account for more than two-thirds of my

equity positions outside the U.S., and 40% of my entire equity 
positions. 
Whether "the bull market of a lifetime" will survive the next 
few months will be the subject of a new experiment; whatever the 
outcome, the thesis has stood me in good stead in managing my 
investment fund up to this point. I hope that reopening the exper- 
iment will help to focus my mind in the same way as it did last 
time. 
f Quantum Fund 
Profits & Losses 
, First Half of 1986 
(in millions of dollars)

(in millions of dollars) 
Stocks + 341.2 
Bonds + 22.3 
Currencies + 53.3 
Oil + 82.0 
Gold - 2.2 
Miscellaneous - 16.8 
Total + 479.8

control Period: 12/9 1985 to 7/20 1986 
70% 
60% 
50% 
40% 
30% 
20% 
10% 
0% 
-10% 
-20% 
-30% 
-40% 
-50% 
-60% 
-70% 
Mar 31 Apr 14 Apr 28 May 12 May 28 lun 9 Jun 23 lul 7 - S&P 500 Index - EAFE in U.S. dollars - Crude Oil - Dcutsche Mark U.S. Government Bonds 
Mar 31 ~pr 14 Apr 28 May 12 May 28 ~un 9 jui 23 ~ui 7 - U.S. Stocks - Foreign Stocks ---..- Crude Oil 
Currencies Bonds 
Notes:

Notes: 
(I) All prices are calculated as percent change over the first day shown. 
(2) EAFE is Morgan Stanley's Capital international index in U.S. dollars for European, Australian. 
(3) The Oil and the Government Bond prices are the closing prices of the nearest futures contracts. 

70% 
60% 
50% I 
40% 
30% 
20% 
10% 
0% 
Mar 31 Apr 14 Apr 28 May 12 May 26 Jun9 lun Z3 jut 7 - Deutsche Mark - Yen --- Pound Sterling - Swiss Franc 
2.0 
1.8 I 
-1.0 :'I, , , , , , , , , , , , , , , ,I 
Apr 11 Apr 25 May 9 May 23 Jun6 Jun20 J~14 lull8 
ESS3 Deutsche Mark Yen Pound Sterlmg 0 Fmh Other 0 U.S. Dollar 
Notes:

Notes: 
(2) Net currency exposure includes stock, bonds, futures, forwards, cash, and margins, and equds 

70% 
60% 
50% 
40% 
30% 
20% 
10% 
0% 
-10% 
Mar 31 Apr 14 Apr 28 May 12 May 26 Jun9 Jun 23 JUI 7 - Standard and Poor's 500 lndcx - Fund's Net Asset Value Per Share 
M& 31 A& 14 A~; 28 ~ay 12 May 26 Jun 9 Jun 23 Jul 7 
U.S. Stocks U.S. Stock Market Index Futures

Note: 
-i"

700 1 
""""'I"""'"I"""".I"'"'".,"""...~""'. 
Mar 31 Apr 14 Apr 28 May 12 May 26 Jun 9 
Conhnental European Japanese British 
Fmnish B Far Eastern

I FOREIGN STOCKS P/L 
Notes: 
foreign stock positions. ar" 
(2) Far Eastern positiow include Hong Kong, Korea, Taiwan, Australia, and Thailand.

Mar 31 Apt 14 Apr 28 May 12 May 26 Jun 9 Jun 23 jul 7 - Oil - Cold 
Mar 31 ~ir 14 ~pr28 h4iy 12 26 jin 9 ];n 23 ~i1 7 I Oil - Gold

Mar 31 Apr 14 A~; 28 Ma; 12 May 26 ~un 9 JU~ 23 lui 7 - U.S. Treasury Bill Futures - U.S. Government Bond Futures 
-....... ..... Japanese Government Bond Futures 
-0.8 
-1 I::~~ Apr4 Apr 11 Apr 25 May 6 May 23 Jun 6 Jun 20 Jul 4 Jul 12 
U.S. Short Tenn Bonds U.S. Long Term Bonds

, 
FIXED INCOME SECURITIES P&L 
- U.S. Short Term Bonds ---- U.S. Long Term Bonds 
. , . , . . . . . . . ... . Japanese Long Term Bonds 
Notes: 
(21 All U.S. Government Bonds are reduced to a common denominator of*-year Government 
Bonds. The basis of the conversion is the effect on price of a given change in yield. For instance.

$100 million in face value of +year Treasury Notes are equivalent to $28.5 million in market 
Bonds. For ipstance, as of June 30, 1986 $100 million in face value of Japanese Government 
Bonds had the same volatility as roughly $66.2 million in 30-year U.S. Government Bonds. We 
have not adjusted for this difference. 

PHASE 2: JULY 1986-NOVEMBER 1986 
MONDAY, JULY 21,1986 * 
1 The possibility of a deflationary spiral has never been far from my 
thoughts. Indeed, it was the thesis that was uppermost in my 
mind when I started the real-time experiment. Eventually I dis- 
carded it in favor of a bull market thesis, but I kept on considering 
it and occasionally acted on it during the control period. 
The thesis, as I see it at present, rests on the collapse in oil

prices. In the long run, lower oil prices ought to stimulate the 
economy because they reduce production costs and enhance dis- 
posable income. The effect is similar to a tax cut, with the addi- 
tional advantage that it comes at the expense of OPEC and not of 
the U.S. Treasury. But in the short run, the impact is negative. 
First, there is a direct hit against oil production and exploration 
expenditure. Even more important, when producers' prices are

falling, there is a powerful inducement to delay purchases. With 
nominal interest around 7% in the U.S. and 4% in Japan, while 
producers' prices are dropping at an 8%% rate in the U.S. and 
even faster in Japan, what can be better than building up cash 
balances, preferably in Japanese yen? The deflationary effect is 
supposed to be temporary, because purchases cannot be delayed 
forever, especially if consumer demand, stimulated by lower in-

terest rates and lower prices, picks up. But while it lasts, there is 
a danger that the burden of accumulated debt will come crashing 
down, obliterating the prospect of an eventual pickup in demand. 
The announcement last week that LTV Corp. went into volun- 
* Charts showing the posture and performance of Quantum Fund in Phase 2, 
follow p. 277. The key to the parenthetical note references (1) through (6) in the 

Phase 2: July 1986-November 1986 237 
tary reorganization provides the paradigm. Operating under the 
protection of the courts, LTV Corp. can lower its costs structure 
and compete more effectively until Bethlehem Steel is also 
pushed into bankruptcy and eventually the whole industry goes 
broke. While the drama is acted out, customers are likely to order 
from hand to mouth. The scenario is a dramatization of what goes 
on, in one form or another, in many sectors of the economy. Texas

and other ~il-~roducin~ regions are rapidly turning into disaster 
areas. The tax reform bill threatens to destroy the market for com- 
mercial real estate; it also weakens an already weak capital goods 
sector. Agriculture is in the depth of a depression, and defense 
spending, which has been one af the driving forces irz the econ- 
omy, is on the decline. Consumer spending remains the last major 
source of strength. If consumer confidence is shaken, final de-

mand may never pick up as it is supposed to. As Keynes said, in 
the long run we are all'dead. 
The situation is exacerbated by instability in the currency mar- 
kets. The decline in the dollar greatly reduces the scope for mon- 
etary stimulation. ~he'~ros~ect for a vicious circle developing in 
which a weak economy and a weak dollar become mutually self- 
reinforcing is greater now than at any time since the inception of 
the real-time experiment.

the real-time experiment. 
The combination of a near-term negative and a long-term posi- 
tive impact is called a J curve. The term is usually used in con- 
nection with currencies, but it can also be appliew oil prices. It 
depicts the effects of a one-time fall in value. If the depreciation 
is continuous, the downward slope of the J curve is extended 
until it becomes more appropriate to speak of a slippery slope 
than a J curve.

than a J curve. 
I have been aware of the dangers inherent in the collapse of oil 
prices long before the markets began to recognize them and I have 
been lulled into a false sense of security by the fact that the mar- 
kets continued to ignore them. Indeed, I was more preoccupied 
with possible signs of a pickup until recent market action gave 
me a rude reminder. When the stock market went into a tailspin 
on July 7, my first reaction was to treat it as a typical technical

correction in a bull market which in this case seems to occur at 
the beginning of each quarter. I realized that we are in a situation 
where any break in the stock market could be self-validating; still, 
I found it difficult to believe that the break would come exactly 
when the market was due for a technical correction. Moreover, it

238 The Real-Time Experiment 
would be most unusual for the turn to be called correctly by a 
4 majority of technical analysts. Only a week later, when the de- 
cline exceeded the bounds of a technical correction, did I take it 
seriously. 
I accept the bearish thesis not as a valid prediction of what is 
in store for us but as a potent influence in financial markets. At 
the same time, I see no reason to abandon the bullish thesis. On

the contrary, if it survives the severe test it is currently subjected 
to it will be reinforced and its life span extended. Thus I find 
myself in the awkward position of having to operate with two 
contradictory theses, at least in the short run. The bearish thesis 
is the more potent rightnow, but 1 cannot ciaim to have acted 
upon it either in anticipation or at inception. Thus, there is a 
1 danger that I act upon it just as its influence in the market be-

comes fully felt-in other words, I sell at the bottom. 
I have found myself in similar situations often before and I have 
developed certain techniques for dealing with them. Indeed, it is 
more usual for me to operate with two at least partially contradic- 
tory theses than to stake everything on one thesis as I did at the 
end of Phase 1. 
As a general principle, I do not dismantle positions that are 
built on a thesis that remains valid; rather, I take additional posi-

tions in the opposite direction on the basis of the new thesis. The 
result is a delicate balance that needs to be adjusted from moment 
to moment. If the balancing act fails to protect the portfolio, I have 
to cut back all around in order to assure survival. If the balancing 
act is successful, I gain liquidity without having to sacrifice desir- 
able positions. To illustrate: if I start with a fully invested position 
and then sell short an equal amount, a 20% decline, even if it

affects the longs and the shorts equally, leaves me only 80% in- 
vested on the long side. If I cover my shorts at the right time, I 
come out way ahead, but even if I cover my shorts with a loss I 
am better off than if I had sold my longs at the wrong time. In 
practice, the operation is much more complex because the balanc- 
ing act is not confined to the stock market. 
Take the present case.* I reacted rather late. The break was

already a week old, and the market was 5% off its peak when I 
* Again, readers not particularly interested in my market maneuvers are advised 
to skip the rest of this chapter, with the exception of the entry for Oct. 22, 1986, 
which analyzes an interesting boomlbust sequence in the Japanese stock market.

Phase 2: July 1986-November 1986 239 
started to move. On Monday, July 14, I actually bought some S&P 
futures on the argument that, if we are dealing with a technical 
reaction, the market ought to close higher. The Dow had dropped 
63 points the previous Monday, July 7, and the bears would ex- 
pect another sharp drop: on the subsequent Monday to establish a 
cascade-like bear market. When the market did in fact close lower, 
I reversed myself on the; following day and by the end of the week

I built up a short position that probably outweighs my long posi- 
tions. I also shorted some long bonds and went long some T-bill 
futures. Then I piled into the Japanese bond future market, and 
doubled up on my short position in U.S. government bonds. The 
idea behind these maneuvers is that eventually i expect conc~rtzd 
action to reduce interest rates but, with the dollar declining, U.S. 
bonds may react negatively while Japanese bonds would move

up. The day-by-day evolution of the portfolio structure is shown 
in the tables following p. 249. 
I am now in the position I wish to be in, but my posture is liable 
to change from minute to minute. I shall have to be much more 
active and nimble than I had been hitherto until the battle be- 
tween the two conflicting theses is resolved. For instance, I cov- 
ered 500 S&P futures contracts today (Monday, July 21) in order 
to be able to sell more at higher prices if and when the disappoint-

ment that the "cascade" did not continue precipitated a short- 
covering rally. 
Which way I shall move next will be dictated bythe outcome 
of the OPEC meeting starting next Monday. If it breaks down, I 
shall prepare for the worst; if, against all prevailing expectations, 
it manages to reach an agreement, I shall have to reassess the 
situation. 
MONDAY EVENING, JULY 28,1986 
It is difficult to give a blow-by-blow account of my maneuvering.

To summarize my activities last week: I reduced my short posi- 
tion in S&P futures to 5000 contracts ($587 million) at a modest 
loss; I covered part of my short position in U.S. government bond 
futures at a modest profit; and I also took a profit on a portion of 
my most recently acquired dollar short positions. The net effect 
is to reduce my risk marginally all around and to put me in what 
I believe to be a fully hedged position.

I believe to be a fully hedged position. 
Today, Monday, I took my profit on the balance of my short

240 The Real-Time Experiment 
July 28,1986 
Closing % Change Closing O/O Change 
7/28/86 from 7/21 7/28/86 from 7/21 
DM 2.1515 - 1.5 S&P 500 240.23 +1.7 ' 
V 158.30 f11.9 U.S. T-Bonds 97 - 3.0 
E 1.4795 - 1.3 Eurodollar 93.43 - .2 
Gold 347.9 - 2.0 Crude Oil 10.90 - 16.7 
Japanese Bonds 103.31 0 
QUANTUM FUND EQUITY $1,514,000,000 
Net Asset Value Per Share $10,126 
Change from 7/21/86 2.4% 
Change from 8/16/85 131.2% 
Net Net 

Net Net 
(2) (2) 
Positions (1) Long Short 7/21 Exposure (6) Long Short 7/21 
Stocks DM-related 678 - 117 
US Stocks 1,020 (99) -82 Japanese Yen 434 - 115 
US Index Pound Sterling (25) 0 
Futures (1,053) - 103 US Dollar 427 + 268 
Stocks 581 - 23 Currencies 341 + 139 
Bonds (3) 
US Gvt. 
Short 
Term (4) 59 + 30 
Long 
Term (572) -2 
Japanese 
(5) 1,663 + 329 
Oil (37) +6 
Gold + 34

Oil (37) +6 
Gold + 34 
position in U.S. government bond futures. Then the dollar fell to 
new lows for some unexplained reason and I felt obliged to jump 
off the fence on the bearish side. I was part of the crowd dumping 
bonds and stock index futures. I sold out the S&P index futures I 
had bought back at higher prices the week before, as well as the 
bond futures I had covered at higher prices earlier this morning.

Phase 2: July 1986-November 1986 241 
It was not clear to me whether the markets were anticipating a 
positive or a negative cohclusion to the OPEC meeting; all I could 
see was that the dollar was falling for whatever reason and that 
was bearish for bonds and stocks. A market move that has no clear 
explanation can be all the more scary. I decided to act first and to 
look for an explanation 'later. I shall reexamine the situation to- 
morrow and, if necessary, reverse today's moves.

morrow and, if necessary, reverse today's moves. 
THURSDAY EVENING, JULY 31,1986 
On Tuesday, I took a modest profit on the S&P futures I had sold 
on Monday and I also covered my bond futures OG!~ to sell part 
of them out again at higher prices. 
On Wednesday, the stock market made a modest new low. I 
tried to cover more S&P futures but the futures market rallied and 
I got only 1100 contracts done. I also continued to short into a 
rising oil market.

rising oil market. 
This morning, the dollar made new lows and I intend to get 
back into a more bearish position in stock index futures. It seems 
that the OPEC meeting has not succeeded in more than papering 
over the differences. The next move in oil should be down. This 
was the signal I was waiting for in deciding which way to get off 
the fence. 
The case for a recession also seems to be getting stronger. Be- 
yond the short-term case based on a deflationary spiral there is

also a long-term case based on a decline in capital spending. The 
instability of financial markets provides a powerful disincentive 
to fixed capital formation all over the world. In the U.S., tax re- 
form adds to the uncertainties; ifi Europe and Japan, the desline 
of the dollar puts downward pressure on profit margins. The trou- 
ble is that the governments have much less leeway than usual to 
embark on countercyclical policies. This is particularly true of

the U.S., which is hemmed in by the need to maintain the confi- 
dence of foreign investors. Japan and Europe could do more, but 
they are moving slowly. In the meantime, the weight of accumu- 
lated debt is pressing: Bethlehem Steel suspended dividend pay- 
ments on its preferred stock. 
The downside seems open-ended, the upside limited. After yes- 
terday's rally, the stock market is still in a mold that would fit a 
normal technical correction; today may be the day to break the

mold. If this is true, my actions will undoubtedly contribute to it.

242 The Real-Time Experiment 
Closing O/O Change Closing O/O Change 
7/31/86 from 7/28 7/31/86 from 7/28 
DM 2.1040 + 2.2 S&P 500 236.59 - 1.5 
Y 155.30 + 1.9 U.S. T-Bonds 97 0 
E 1.4928 + .9 Eurodollar 93.46 0 
Gold 352.00 + 1.2 Crude Oil 11.73 + 7.6 
Japanese Bonds 103.64 + .3 
QUANTUM FUND EQUITY $1,503,000,000 
Net Asset Value Per Share $10,050 
Change from 7/28/86 - 3% 
C'nange from Fii'i6i85 + 129.5% 
Portfolio Structure (in millions of dollars) . 
I Net Net 
(2) (21

I Net Net 
(2) (21 
Positions (1) Long Short 7/28 Exposure (6) Long Short 7/28 
I Stocks DM-related 679 +I 
1 US Stocks 983 (106) -44 JapaneseYen 431 -3 
US Index Pound Sterling (15) +10 
Futures (973) +80 US Dollar 408 - 19 
1 Foreign Other 
Stocks 582 (44) -43 Currencies 171 - 170 
1 Bonds.(B) 
US Gvt. 
Short 
Term (4) 124 + 65 
Long 
Term (447.) !-I30 
Japanese 
(5) 1,686 + 23 
Oil (73) -36 
Gold 
MONDAY EVENING, AUGUST 4,1986

Gold 
MONDAY EVENING, AUGUST 4,1986 
The short position I took on last Thursday seemed to be working: 
the index futures closed at a new low on Friday, setting up for 
another black Monday. Today, the stock market opened lower, 
but oil was higher from the start. I was concerned that OPEC may

Phase 2: July 1986-November 1986 243 
, Aug. 4,1986 
8/4/86 from 7/31 8/4/86 from 7/31 
Y 154.30 + .6 U.S. T-Bonds 9725/3z + .8 
£ 1.4695 - 1.6 Eurodollar 93.57 +.1 
Gold 360.30 + 2.4 Crude Oil 13.29 + 13.3 
I Japanese Bonds 104.11 + .5 
QUANTUM FUND EQUITY $1,504,000,000 
Net Asset Value Per Share $9,834 
Change from 7/31/86 - 2.1% 
Change from 8/19/85 i 224,6% 
Net Net 
(2) (2)

Net Net 
(2) (2) 
Positions (1) Long Short 7/31 Exposure (6) Long Short 7/31 
Stocks DM-related 601 - 78 
US Stocks 1,015 (96) +42 Japanese Yen 421 - 10 
US Index Pound Sterling (15) 0 
Futures (703) +270 US Dollar 497 + 89 
Stocks 562 (44) -20 Currencies 197 + 26 
Bonds (3) +- 
US Gvt. 
Short 
Term (4) 122 -2 
Long 
Te2m (333) +59 
Japanese 
(5) 2,388 + 702 
Oil (85) -12 
Gold

Gold 
come to some kind of agreement and I tried to cover half my short 
position. Then the details of a deal began to filter through and the 
stock market rallied. I managed to cover only a quarter of my short 
position. I realized a modest profit on the completed transaction 
but I have an unrealized loss on the part I failed to cover. My 
present inclination is to take the loss, because the bearish case

244 The Real-Time Experiment 
has been undermined by today's deal on oil quotas. The fact that 
Iran and Saudi Arabia came to terms is highly significant: it indi- 
cates that it is not in Saudi Arabia's political and military interest 
to see the price of oil go any lower. The deal may come apart, but 
that can happen only later. In the meantime, it does not make 
sense to be short in either oil or stocks. Unfortunately, I am short

in both. I want to disengage myself, but I may have to be patient: 
there are many others in my position and after the first rally there 
may be room for second thoughts. One way or another, I have to 
be prepared to take a loss. 
SATURDAY, AUGUST 9,1986 
I have reduced my exposure all around in the course of the week. 
On Tuesday, I covered my short positions in index futures and 
oil and bank stocks; I also sold some of my currencies and short-

term bonds. On Wednesday, after the first wave of short covering 
receded, I started covering my short positions in oil. On Thurs- 
day, I covered my short position in bond futures. Today, I sold 
the bulk of my currencies. 
The only major positions I am left with are in stocks and in 
Japanese bond futures. The only new exposure I took on is a short 
position in U.S. government bond futures. This was a tactical 
move I made today after a sharp short-covering rally and it is

hedged in a way by my Japanese bond futures. 
The asset value of the Fund suffered its first setback since the 
beginning of January: the value of the shares dropped by 4.2% in 
the course of the week. The losses came primarily from the oil 
gamble and from some sf my stock posiiiuns. The change in the 
market environment has finally caught up with us: several of our 
stock investment concepts were punctured and, without a suc-

cessful hedging operation, our asset value suffered. We have prob- 
ably not yet experienced the negative impact to the full extent: 
usually everything that can go wrong does so at the same time. 
That is why I prefer to retrench all around when things begin to 
go wrong. Two weeks of hectic activity produced no tangible re- 
sults: it is time to become more quiescent. I am still too much 
involved in the day-to-day movements of the market, but I shall

try to regain my perspective. With reduced exposure, I can reas- 
sess and regroup more easily. 
I accept the OPEC agreement as a major event. The oil-produc-

Phase 2: July 1986-November 1986 245 
Au~. 8,1986 
8/8/86 from 814 8/8/86 from 814 
DM 2.0660 + 1.0 S&P 500 236.88 + .4 
Y 153.75 + .4 U.S. T-Bonds 99O3/3~ + 1.3 
£ 1.4765 + .5 Eurodollar 93.61 0 
Gold 375.60 + 4.2 Crude Oil 14.83 + 11.6 
I Japanese Bonds 104.01 -.I 
QUANTUM FUND EQUITY $1,472,000,000 
Net Asset Value Per Share $9,628 
Change from 8/4/86 - 2.1% 
Change from 8/16/85 + 219.9% 
Net Net 

Net Net 
(2) (2) 
Positions (1) Long Short 814 Exposure (6) Long Short 814 
Stocks DM-related 164 - 437 
US Stocks 1,002 (47) +36 Japanese Yen 141 - 280 
US Index Pound Sterling (25) -10 
Futures + 703 US Dollar 1,192 + 695 
Stocks 593 (30) +45 Currencies 177 - 20 
Bonds (3) 
US Gvt. 
Short 
Term (4) 49 - 73 
Long 
Tei lm (552) -169 
Japanese 
(5) 2,385 -3 
Oil + 85 
Gold (15) -15

Oil + 85 
Gold (15) -15 
ing countries went to the edge of the abyss and recoiled: they are 
likely to stay away from the abyss for some time. The inverse 
supply curve for oil works in both directions: once the price of 
oil rises, the pressure to pump oil at any price is diminished. In 
short, the oil cartel gained a new lease on life. Its duration is 
uncertain, but it is bound to be long enough to base my invest-

246 The Real-Time Experiment 
ment decisions on it. I expect oil prices not below $15 and more 
likely $18 by the end of the year. 
Where does that leave me? My negative scenario was predicated 
on the collapse of oil; should I abandon it and turn unreservedly 
bullish again? That was my first reaction but I am held back be- 
cause I am aware of too many negatives. Having passed one hur- 
dle, namely, oil, there are others behind it. The most important is

the weakness of the dollar. I prefer to remain cautious until the 
dollar is stabilized. 
In casting around for a negative case I find myself returning 
to the argument I started with at the beginning of the real-time 
experiment. At that time, the Imperial Circle was unwinding 
and there was a danger it would start spinning in the opposite 
direction: a weak economy would produce a weak dollar and 
prevent a decline in interest rates. Both the economy and the

dollar are weak enough to render this scenario realistic. What 
is there to prevent it? I believe only the realization of the danger 
will save us. The stock market is telling us that we are heading 
into a recession; the weight of bad debt is accumulating; and 
protectionist pressures have reached such a point that Congress 
fell only a few votes short of overriding a presidential veto on 
the subject. The authorities must realize that something has to

be done. They had managed to forge a consensus once before, 
at the Plaza Group of Five meeting. Under the pressure of cir- 
cumstances it would not be so difficult to do it again. Japan and 
Germany could lower their interest rates, and the United States 
could cooperate in supporting the dollar. Volcker flew off to 
Emminger's funeral in Germany over the weekend and I have 
no doubt the subject will be discussed. That is why I sold my

currencies yesterday. Shorting U.S. bond futures makes less 
sense, except as a hedge. If the dollar continues to make new 
lows, I intend to build up the position as a replacement for my 
short position in the dollar; if the dollar stabilizes I can go 
long in stock index futures against it. In any case, I can offset 
my short position in U.S. bonds against my long position in Jap- 
anese bond futures. 
In sum, I continue to operate with two alternative scenarios,

but, instead of oil, the dollar has become the critical variable. 
If the authorities succeed in stabilizing the dollar, I shall back 
the bullish scenario more confidently; if they fail, the vicious 
circle looms. At present, I am willing to bet on a positive reso-

Phase 2: July 1986-November 1986 247 
lution, but only cautiously. Having surmounted one hurdle, we 
ought to be able to pass the next one. But if covering my dollar 
positions turns out to be a mistake I shall have to either en- 
gage in some fancy footwork or take it on the chin. Given the 
futility of my hedging1 exercise to date, I shall probably opt for 
the latter. After all, I hdve no leverage left in the portfolio to worry 
about. 
I 
MONDAY EVENING, AUGUST 18,1986

about. 
I 
MONDAY EVENING, AUGUST 18,1986 
The stock market has ,turned in a very strong performance, the 
bond market has also ~emained firm, and the currencies seem to 
have stabilized. The asset value of the fund reached a new high. I 
am now ready to opt for the bullish scenario with greater confi- 
dence. 
We have been to the 'brink and we are in the process of pulling 
back from it. The groundwork has been laid for a coordinated

reduction in interest rates. With oil prices rising we are heading 
for a period of inventory accumulation. With currencies stabiliz- 
ing, the beneficial effects of the decline in the value of the dollar 
will begin to be felt. These short-term positives should outweigh 
the long-term negatives such as the downturn in construction and 
the weakness in capital spending. The net result should be a con- 
tinuation of the substandard growth we have been experiencing.

Against this background, the stock markets of the wsrld may con- 
tinue to reach new heights. The tax reform bill may exercise a 
dampening influence for the rest of this year because both long- 
term capital gains and short-term losses will have more favorable 
tax treatment this year than next; but this consideration may be 
already reflected in the market. Professional investors have raised 
a lot of cash and done a lot of hedging. If there is going to be a

surprise it will be on the upside. This is quite a turnabout from a 
few weeks ago when I felt that the upside was limited and the 
downside open-ended. 
I am now ready to conclude Phase 2 of the experiment. Instead 
of a turning point, it turned out to be an interlude in what I still 
consider a bull market. I shall revert to a more leisurely style of 
management and less frequent reviews. The Fund is well posi- 
tioned, although I would be happier with a somewhat larger long

position in stocks and, to be adventurous, with a long position in 
oil.

248 The Real-Time Experiment 
- - - - 
Aug. 18,1986 
8/18/86 from 818 811 8/86 from 8/8 
DM 2.0170 + 2.4 S&P 500 247.38 + 4.4 
Y 154.32 - .4 U.S. T-Bonds 10l04/3z + 2.0 
E 1.4900 + .9 Eurodollar 93.81 + .2 
Gold 376.40 + .2 Crude Oil 15.61 + 5.3 
Japanese Bonds 105.08 f1.0 
QUANTUM FUND EQUITY $1,594,000,000 
Net Asset Value Per Share $10,423 
Change from 8/8/86 + 8.3% 
Change from 8/16/85 + 138.0% 
Net Net

Net Net 
(2) 12) 
Positions (1) Long Short 818 Exposure (6) Long Short 8/8 
Stocks DM-related 169 +5 
US Stocks 1,088 (40) +93 Japanese Yen 199 + 58 
US Index Pound Sterling (19) +6 
Futures 347 + 347 US Dollar 1,245 + 53 
Stocks 677 (19) +95 Currencies 223 + 46 
Bonds (3) 
US Gvt. 
Short 
Term (4) 43 -6 
Long 
Term (465) .+ 37 
Japanese 
(5) 2,427 + 42 
1 Commodities 
, oil 28 + 28 
, Gold 11 + 26

, oil 28 + 28 
, Gold 11 + 26 
The rather hectic activity of the last month is summarized 
graphically in the tables that follow p. 249. 
MONDAY, SEPTEMBER 8,1986 
Last Monday, gold, influenced by a booming platinum market, 
broke the $400 barrier, and bonds and stocks sold off rather

Phase 2: July 1986-November 1986 . 249 
sharply. I ignored the sell-off and by Thursday I seemed to be 
justified: the Dow Jones made a new high. But the other indexes 
did not follow, and the whole market weakened on Friday. There 
has been a change in leadership: cyclical and oil stocks have come 
to the fore, but the old leadership, where investors have large 
profits, is acting poorlj. I believe the tax bill is responsible: the

tax rate on long-term capital gains is going to be higher next year. 
I 
Sept. 5,1986 
9/5/86 from 811 8 9/5/86 from 8/18 
DM 2.0487 - 1.6 S&P 500 250.48 + 1.3 
Y 155.40 - .7 U.S. T-Bonds 97l2/32 - 3.7 
£ 1.4940 + .3 Eurodollar 94.09 + .3 
Gold 422.80 + 12.3 Crude Oil 16.37 + 4.9 
Japanese Bonds 105.15 + .1 
QUANTUM FUND EQUITY $1,638,000,000 
Net Asset Value Per Share $10,606 
Change from 8/18/86 + 1.8% 
Change from 8/16/85 + 142.2%

Change from 8/16/85 + 142.2% 
Net Net 
(2) (2) 
Positions (1) Long Short 8/18 Exposure (6) Long Short 8/18 
Stocks DM-related 153 - 16 
US Stocks 1,214 (33) +I33 Japanese Yen 162 - 37 
US Index Pound Sterling 5 +24 . 
Futures 499. + 152 US Dollar 1,318 + 73 
Stocks 654 -4 Currencies 247 + 24 
Bonds (3) 
US Gvt. 
Short 
Term (4) 11 - 32 
Long 
Term + 465 
Japanese 
(5) 2,385 - 42

Long 
Term + 465 
Japanese 
(5) 2,385 - 42 
oil 76 + 48 
Gold - 11

POSITION S&P 500 FUTURES 
(September Contract) 
249 
Jul 14 Jul 18 Jut 24 Jul 30 Aug 5 248 - 
247 - 
246 - 
245 - 
244 - 
243 - 
7 I Aug 11 /Ir- 
Aug 15 kkll 
233 - 
232 - 
231 I~I~~~I~I~I~I~I~I~I~I~I~~ 
Jul 14 Jul 18 Jul 24 Jut 30 Aug 5 Aug 11 Aug 15

PROFITS AND LOSSES ON S&P INDEX FUTURES 
(US $ Millions) 
Lbte 
Jul 14 
Jul 15 
Jul 16 
Jul 17 
Jut 18 
Jul 21 
Jul 22 
Jul 23 
Jul 24 
JuI 25 
Jul 28 
Jul 29 
Jul 30 
Jul 31 
Aug 1 
Aug 4 
Aug 5 
Aug 6 
Aug 7 
Aug 8 
Aug 11 
Aug 12 
Aug 13 
Aug 14 
Aug 15 
Aug 18 
Aug 19 Jut 14 Jul 18 Jul 24 Jul 30 Aug 5 Aug 11 Aug 15 
Suminary of S&P Index Transactions 
Outst. 
Close Position 
Price $ Mill. 
238.3 153 
235.05 (301) 
235.1 (647) 
236.15 (655) 
236.85 (982) 
236.35 (921) 
238.4 (929)

238.4 (929) 
237.95 (602) 
238.4 (595) 
240.9 (602) 
234.85 (939) 
235.1 (588) 
237.7 (484) . 
235.95 (952) 
233.15 (671) 
237.05 (682) 
237.75 0 
237.3 0 
237.45 0 
238.1 0 
241.3 0 
244.2 61 
246.45 55 
247.55 37 
248.05 70 
248.25 256 
247.4 292 Bought 
Amount 
$ Mill. Price 
153 238.98 Sold 
Amount 
$ Mill. Price Cum. Real. 
P&L 
$ Mill. Uml. 
P&L 
$ Mill. 
(0.435) 
3.059 
4.377 
1.523 
(1.421) 
0.613 
(7.376) 
(3.607) 
(4.732) 
(10.982) 
4.668 
2.215 
(3.565)

CRUDE OIL 
(NYM September Contract) 
Jut I4 Jul 18 Jul 24 Jul 30 Aug 5 Aug 11 Aug 15 
POSITIONS 
Jul 14 Jul 18 Jul 24 Jul 30 Aug 5 Aug 11 Aug 15

CRUDE OIL PROFITS AND LOSSES 
Summary of Transactions in Oil-Related Contracts1 
Tmnsoction Avg. Totol Real P&L Totol 
Amount Rica Outstond. In Period P&L ms mu ms us$ qs 
Fmm To Mill. &ur. Mill. Mill. Mtll. 
Jul 14 Outstanding short position 15.478 (25.534) " 7.750 
Jul 15 Jul 17 Increased short position (14.029) 13.038 (41.924) 0.000 7.466 
Jul 21 Jul24 Bought back 13.737 12.455 (26.535) 3.090 9.032 
Jul 25 Ju131 Increased short position (49.679) 11.449 (87.654) 0.877 9.395

Aug 1 Aug 8 Covered short position 99.156 15.271 0.000 (19.824) (13.186) 
Aug 12 Aug 19 Built new long position 29.44 $5.405 28.837 0.000 (13.789) 
1 Figures include positions in NYM-Crude and NYM-Heating Oil contracts for various months. 
Prices shown are weighted averages for all outstanding contracts expressed in US S per barrel.

DEUTSCHE MARK 
0.456~11~IIIII~ 1~~~1~~~~1~1~111 
Jul 14 Jul 18 Jul 24 Jul 30 Aug5 Aug 11 Aug 15 
POSITIONS 
. .-I 
Jul 14 Jul 18 Jul 24 Jul 30 ~&5 ' ~ug 11 Aq 15

DEUTSCHE MARK PROFITS AND LOSSES 
Summary of Transactions in Deulache Mark Future and Fornard Contracts1 
Tmnsmtion Avg. Total PbL on 
Amount A.ice Outstond. T)ph~w. 
US$ USY US$ US$ 
lkte Mode Mill. IDM Mill. Mill. 
Jul 14 Outstanding long position 0.4580 712.067 
Jul 24 Decreased long position 125.182 0.4692 598.683 2.990 
Aug 1 Decreased long position 81.000 0.4809 530.133 3.857 
Aug 5 Decreased long position 150.380 0.4784 377.627 6.418

Aug 8 Decreased long position 297.205 0.4843 84.431 16.131 Totol 
PbL 
"S Mlll. 
7.855 
17.108 
32.103 
29.977 33.986 
1 Figures include positions in D. Mark Sep. futures and forward contracts due 9/17. 
Price of forward contracts is assumed equal to price of futures.

YEN 
Jul 14 Jul 18 Jul 24 Jul 30 Aug5 Augll Aug15 
POSITIONS 
Jul I4 Jul 18 Jul 24 Jul 30 AugS Aug 11 Aug 15

YEN PROFITS AND LOSSES 
Jul 14 Jul 18 bul 24 jul 30 hug5 Aug 11 Aug 15 
Summary of Troas~ctionr, in Japanese Yen Fuhve and Forward Contracts1 
. Tmnsaction Avg. Total .P&L on Total 
Amount Price Outstond. Tmnsac. P&L 
Tmnsoction US$ US&' US$ 
Lhte Md? Mill. 100 Yen Mill. Mill. " $ MI//. 
Jul 14 Outstanding long position 0.6122 486.666 46.742 23.634 
Ju1 24 Decreased long position (132.040) 0.6408 364.170 5.215 33.178

Aug 5 Decreased long position (96.870) 0.6458 269.812 3.140 35.747 
Aug 8 Decreased long position (188.307) 0.6507 83.977 8.382 38.161 
1 Figures include positions in Yen Sep. futures and fonvard contracts due 9/17. 
price of forward contracts is assumed equal to price of futures.

258 The Real-Time Experiment 
The market is also concerned about inflation. My strategic view 
I has not changed: if the authorities can coordinate their policies, 
we ought to have continued subdued growth. I am encouraged by 
the relative stability of the dollar. Nevertheless, it seems that the 
stock market needs to test the downside. At present, I don't expect 
much more than, say, 40 points on the Dow Jones. Nevertheless, I 
Sept. 8,1986 
Closing % Change Closing % Change

9/8/86 from 91.5 9/8/86 from 91.5 
DM 2.0750 - 1.3 S&P 500 248.14 - .9 
?I! 156.00 - .4 U.S. T-Bonds 9624/3~ - .6 
E 1.4835 - .7 Eurodollar 94.04 - .1 
Gold 411.00 - 2.8 Crude Oil 15.62 - 4.6 
Japanese Bonds 104.30 - .8 
QUANTUM FUND EQUITY $1,592,000,000 
Net Asset Value Per Share $10,304 
Change from 9/5/86 - 2.8% 
Change from 8/16/85 + 135.3% 
Net Net 
(2) (2)

Net Net 
(2) (2) 
Positions (I) Long Short 91.5 Exposure (6) Long Short 915 
Stocks DM-related 151 -2 
US Stocks 1,189 (32) -24 Japanese Yen 137 - 25 
US Index Pound Ster!ing C, i-1 
Futures 261 - 238 US Dollar 1,298 - 20 
Stocks 647 - 7 Currencies 223 - 24 
Bonds (3) 
US Gvt. 
Short 
Term (4) 8 -3 
Long 
Term 
Japanese 
(5) 2,360 - 25 
Oil 72 -4 
Gold

Phase 2: July 3986-November 3986 259 
decided to cut my position in S&P futures in half, in order to 
retain the initiative. 
A setback in Japanese stocks and bonds is hurting, but there is 
nothing to be done about it. 
THURSDAY MORNING, SEPTEMBER 1 1,1986 
I have decided to move into a more neutral position. That means 
selling out the rest of my S&P futures, and perhaps even going 
short against my stock positions, or building up my small short

position in government bonds. I have also decided to short the 
dollar, mainly against the DM. 
I expect the U.S. economy to show strength in the third quarter, 
and my information is that the German economy showed a strong 
pickup in the second quarter. The groundwork has been laid be- 
tween the U.S. and Japan for a concerted reduction in interest 
rates in exchange for a concerted move to stabilize the dollar, and 
I believe that Germany would join, albeit reluctantly. Given the

momentary strength, I believe the button will not be pushed until 
and unless a renewed attack on the dollar would force the hand 
of the authorities. It is to hedge against that possibility that I am 
buying DM. I could, of course, lose both on the DM and on Japa- 
nese bonds, if the dollar continues to strengthen; but I consider 
the risk modest. 
The stock market is increasingly dominated bflaX considera- 
tions. These are difficult to read but I believe that on balance the

pressure will be on the downside for the next few months, setting 
up for a strong year-end rally. Where I have no strong convictions, 
I want to reduce my exposure. 
SATURDAY, SEPTEMBER 13,1986 
The last two days' sharp sell-off found me unprepared. I com- 
pleted the program I set for myself before the opening on Thurs- 
day, but obviously that was not enough to protect the port- 
folio: we are suffering a major setback. I am reluctant to make

any further moves because they could easily compound the dam- 
age. Our exposure is not excessive: I do not need to retrench 
immediately. On the other hand, I have very little ammunition 
for further engagement. I intend to do as little as possible.

> 
Sept. 10,1986 
Closing O/O Change Closing % Change 
911 0186 from 918 9/10/86 from 918 
DM 2.0630 -t .6 S&P 500 247.06 - .4 
Y 154.60 + .9 U.S. T-Bonds 972%z + .9 
£ 1.4812 - .2 Eurodollar 94.05 0 
Gold 404.70 - 1.5 Crude Oil 14.88 -4.7 
Japanese Bonds 104.01 - .3 
QUANTUM FUND EQUITY $1,586,000,000 
Net Asset Value Per Share $10,269 
Change from 9/8/86 - -3% 
Change from 6/15/85 i- 134.5% 
portfolio Structure (in millions of dollars) 
Net Net 

Net Net 
(2) 12) 
Positions (1) Long Short 9/8 Exposure (6) Long Short 918 
Stocks DM-related 153 $2 
US Stocks 1,098 (30) -89 Japanese Yen 135 -2 
US Index Pound Sterling 5 -1 
Futures 259 -2 US Dollar 1,293 -5 
Stocks 673 i-26 Currencies 277 + 54 
Bonds (3) 
US Gvt. 
Short 
Term (4) 1 -7 
Long 
Term (~63 -96 
Japanese 
(5) 2,377 + 17 
Oil 96 + 24 
Gold 
This is in sharp contrast with the July/August break, which I

managed to dodge successfully, In a sense, I was faked out by 
that break. Hedging against it left me emotionally exhausted, 
and when the more severe break came I was asleep at the 
switch. 
In retrospect I should have realized that the tax reform bill 
could dislocate the market, coming at a time when the market was

Phase 2: july 1986-November 1986 261 
I Sept. 12,1986 
9/12/86 from 9/10 9/12/86 from 9/10 
DM 2.0597 +'.2 S&P 500 230.68 - 6.6 
% 155.30 -1.5 U.S. T-Bonds 9422/32 - 3.0 
£ 1.4772 - .3 Eurodollar 93.96 - .1 
Gold 416.50 + 4.9 Crude Oil 15.06 + 1.2 
Japanese Bonds 103.05 - .9 
QUANTUM FUND EQUITY $1,484,000,000 
Net Asset Value Per Share $9,610 
Change from 9/10/86 - 6.4% 
Change froin 8/16/85 + 115.5% 
Net Net

Net Net 
12) (2) 
Positions (1) Long shirt 9/10 Exposure (6) Long Short 9/10 
Stocks DM-related 905 + 752 
US Stocks 1,109 (42) -1 Japanese Yen 355 + 220 
US Index Pound Sterling 3 -2 
Futures 55 - 204 US Dollar 221 - 1,072 
Stocks 629 -44 Currencies 249 - 28 
Bonds (3) d 
US Gvt. 
Short 
Term (4) -1 
Long 
Term + 96 
Japanese 
(5) 2,348 - 29 
OiI 97 +1 
Gold

OiI 97 +1 
Gold 
consolidating anyhow. The inducement to sell first and buy back 
later was just about irresistible. The question now is: How far and 
how fast will the market decline? The figure to watch is mutual 
fund redemptions. Interestingly, I do not feel that the downside 
is as open-ended as it was in July: whatever lows we reach in the 
next three months will set the stage for a strong year-end rally,

262 The Real-Time Experiment 
t SUNDAY, SEPTEMBER 28,1986 
Now that the markets have regained some measure of stability, I 
can collect my thoughts and establish a longer-term strategy. The 
main question confronting me is whether the configuration I have 
called the Golden Age of Capitalism is still operative or are we in 
transition to another phase; in the latter case, what is going to be 
Sept. 26,1986 
9/26/86 from 911 2 9!26/86 fmm 9/12

9/26/86 from 911 2 9!26/86 fmm 9/12 
DM 2.0530 + .3 S&P 500 232.23 + .7 
% 154.60 + .5 U.S. T-Bonds 952%~ + 1.0 
£ 1.4360 - 2.8 Eurodollar 94.01 + .I 
Gold 427.20 + 2.6 Crude Oil 14.43 -4.2 
Japanese Bonds 103.36 + .3 
Net Asset Value Per Share $9,728 
Change from 9/12/86 + 1.2% 
Change from 8/16/85 + 122.2% 
Net Net 
(2) (2) 

(2) (2) 
Positions (1) Long Short 9/12 Exposure (6) Long Short 9/12 
Stocks DM-related 990 +85 
USStocks 1,071 (53) -49 JapaneseYen 295 - 60 
US Index Pound Sterling (lo) -13 
Futures (275) - 330 US Dollar 228 +7 
Stocks 623 -6 Currencies 238 -11 
Bonds (3) 
US Gvt. 
Short 
Term (4) 
Long 
Term (180) -180 
Japanese 
(5) 1,986 - 362 
Oil 94 -3 
Gold

Phase 2: July 1986-November 1986 263 
the next configuration? The question is very similar to the one I 
asked at the beginning of the real-time experiment: what is going 
to be the outcome of the Imperial Circle? Indeed, the question 
could be phrased differently: is the "Golden Age of Capitalism" 
an enduring phenomenon or is it merely a temporary expedient 
that has run its course? ' 
Many signs point to the latter alternative. I shall mention only

a few: the steepening of the yield curve; the rise of gold; and the 
disarray in the Group of Five process. The stock market also 
shows signs of a major top, although it has not quite reached the 
state of euphoria that one would expect from "the bull market of 
a iifetime"; in other wards, the bubble is not yet ripe for bursting, 
That is, in fact, the main reason why I have been so reluctant to 
recognize the topping action and preferred to think in terms of a

technical correction. It is by no means certain that the bull market 
is over, but the break bas been too severe to treat it as part of an 
ongoing bull market. It is better to declare the phase I have called 
the "Golden Age of Capitalism" as complete and to try to identify 
the next phase. Even if 'it turns out to be a new phase in the "bull 
market of a lifetime," it is bound to have so many different fea- 
tures as to justify giving it a different name. I am quite uncertain

at present how the situation will unfold. By declaring it a new 
phase, even if it turns out to be a continuation of the old one, I 
avoid getting frozen into an inappropriate mold and force myself 
to maintain an open mind. It is far too early to cow to any defi- 
nite conclusions. 
The previous phase was based on international cooperation 
that has made a controlled descent of the dollar and a coordinated 
reducrion in interest rates possible.

reducrion in interest rates possible. 
The world economy remained sluggish so that monetary stim- 
ulation led to a big bull market in financial assets. The increasing 
disparity between the "real" and the "financial" economies of the 
world created strains that threaten to undermine international 
cooperation and require a new departure if a breakdown is to be 
avoided. Unfortunately, there are no signs of new policy initia-

tives, only squabbling among the allies. It is far too early to pre- 
dict how the impasse will be resolved. I can see three major 
possibilities: 
1. Muddling through: The J curve finally begins to work, providing 
some impetus to the U.S. economy while weakening our major 
trading partners. The world economy remains sluggish and mon-

264 The Real-Time Experiment 
etary policy accommodating. Once it becomes clear that the dis- 
1 integration of the international trading and financial system has 
been avoided, confidence returns and the tremendous liquidity 
that has accumulated is once again invested in financial assets. If 
so, we may yet see "the bull market of a lifetime." 
2. A vicious circle. A weak economy and a weak dollar reinforce 
each other to produce higher interest rates and higher budget def-

icits. Protectionism gains the upper hand and it provokes retalia- 
tion, including debt repudiation. 
3. New policy initiatives. Under pressure from the financial markets 
(a falling dollar, falling bond and stock markets, and rising gold 
prices) the authorities get their act together. The dollar is stabilized 
at the same time as there is another rouna of interesr rate reduc- 
tions. The U.S. and the Soviet Union agree on a disarmament pact,

allowing the military budget to be cut. International debt is finally 
recognized as a political problem and steps are taken to stimulate 
the economies of less developed countries. 
Since the emergence of a vicious circle is bound to evoke a 
policy response, we may distinguish between two main alterna- 
tives: muddling through and a vicious circle followed by new 
policy initiatives. The actual course of events is likely to combine

elements of both. Either way, financial markets are likely to re- 
main under pressure in the near term. 
After the OPEC meeting I made a bet that the quarrel between 
the United States and Germany will be patched up and we shall 
muddle through. I have started to hedge my bet recently; never- 
theless, the outcome of the latest Group of Five meeting has 
proven me wrong. I intend to react to it vigorously. 
I can understand how the impasse was reached. Baker needed

a scapegoat and the Germans refused to be cast in the role. The 
elements of a deal were clearly visible: a U.S. commitment to 
stabilize the dollar in exchange for a German commitment to 
lower interest rates. I have the impression that it was Baker who 
balked. If so, it betrays the weakness of his position: he cannot 
agree to stabilize the dollar before the November elections be- 
cause he has nothing else to offer to fend off protectionist pres-

sures. There is plenty of time till the elections for the financial 
markets to elicit a more adequate policy response. I intend to do 
my share: I plan to increase my DM position by $500 million, my 
short position in U.S. government bonds from $180 to $500 mil- 
lion, and my stock index futures short position from $275 million

Phase 2: July 1986-November 1986 265 
to $750 million. I also want to go long $150 million in gold. The 
downside seems more open-ended then only a few weeks ago: by 
the time the policy disagreements are resolved a vicious circle 
may well be under way. 
WEDNESDAY EVENING: OCTOBER 1,1986 
Oct. 1,1986 
10/1/86 from 9/26 10/1/86 from 9/26 
DM 2.0175 + 1.7, S&P 500 233.60 +6 
.Tlr 153.85 + .5 U.S. T-Bonds 9622/5~ + 1.1 
£ 1.4450 + .6 Eurodollar 94.03 0

£ 1.4450 + .6 Eurodollar 94.03 0 
Gold 425.20 - .5 Crude Oil 15.16 + 5.1 
Japanese Bonds 103.02 - .3 
QUANTUM FUND EQUITY $1,511,000,000 
Net Asset Value Per Share $9,562 
Change from ,9126186 - 1.7% 
Change from 8/16/85 + 118.4% 
, Net Net 
(21 (2) 
Investment from Net Currency fmm 
Positions (I) Long Short 9/26 Exposure (6) Long Short 9/26 
Stocks DM-related 1,4 15 +425 
US Stocks 1,014 (83) -87 Japanese Yen 282 - 13

US Stocks 1,014 (83) -87 Japanese Yen 282 - 13 
US Index Pound Sterling 1 + 11 
Futures (575) - 300 US Dollar (187) -415 
Stocks 635 + 12 Currencies 240 +2 
Bonds (3) 
US Gvt. 
Short 
Term (4) 
Long 
Term (466) -286 
Japanese 
(5) 1,987 +1 
Oil 99 +5 
Gold 150 + 150

266 The Real-Time Experiment 
One tactical mistake begets another: everything I did on Monday, 
4 with the exception of the DM purchase, was wrong. I do not min- 
imize the importance of the pre-summit meeting announced yes- 
terday, but I must be careful not to embark on a vicious circle of 
my own. For the time being, I shall sit tight. Although I have lost 
money getting there, I believe my portfolio is reasonably well 
balanced. If so, I am prepared to sit out a rally in stocks and

bonds, especially as I am going to China for a month. 
WEDNESDAY, OCTOBER 22,1986 
I cut my trip to China short because I was worried about the 
4 Japanese portion of the portfolio. I am now on my way back to 
New York after spending a day in Tokyo. 
The decline in the Japanese stock market has turned into a 
veritable rout in the last few days. The market as a whole has 
dropped by some 15% but the stocks that I own, which are 
all real estate related, are off 25-40% from their recent highs.

The bond market, where I have a large exposure, has also been 
weak. 
Now that I have focused on it, I realize what is happening. The 
appreciation of the yen has gone too far: Japan is losing out to the 
newly industrialized couhtries of the Pacific Basin and exporting 
companies are hurting badly. An easy money policy is not enough 
to cope with the situation; indeed, it has become counterproduc- 
tive by engendering a speculative boom that is bound to end in a

bust. Recognizing this, the authorities have decided to relieve the 
upward pressure on the yen by actively encouraging capital out- 
flows rather than by lowering interest rates any further. The pol- 
icy succeeded, the yen has stabilized, and the market has 
collapsed. 
I have been an active participant in one of the classic boom1 
bust sequences in history and I failed to get out in time. I am now 
badly caught. It is clear that I ought to get out of the market, but

how and when? I don't know what to do because my knowledge 
of the Japanese market is extremely limited. I expect to pay a 
heavy price for my ignorance. 
I find it somewhat embarrassing to get caught in the "bust 
of our lifetime" while writing about the "boom of our lifetime." 
Yet that is what has happened. I believe the collapse of the

Phase 2: July 1986-November 1986 267 
Japanese stock market will prove to be one of the landmarks of 
contemporary financial history. It resembles a classic crash 
more closely than anything we are likely to witness in our 
own market. The Japanese market has become grossly overvalued 
and complacency has become pervasive, as my own behavior 
testifies. Governor Satoshi Sumita of the Bank of Japan issued 1 Oct. 21, 1986 
10121186 from 1011 10121186 from 1011

10121186 from 1011 10121186 from 1011 
DM 1.9845 + 1.6 S&P 500 235.88 + 1.0 
Y 155.10 - 4 U.S. T-Bonds 9422/32 - 2.1 
£ 1.4340 - .8 Eurodollar 93.92 - .1 
Gold 425.20 0 Crude Oil 15.19 + .2 
I Japanese Bonds 101.35 - 1.6 
QUANTUM FUND EQUITY $1,488,000,000 
Net Asset Value Per Share $9,422 
Change from' 1011186 - 1.5% 
Change frorlt 8:l(ilG5 + 115.2% 
, Net Net 
(2) 12) 

(2) 12) 
Positions (1) Long Short loll Exposure (6) Long Short 1011 
Stocks DM-related 1,316 - 99 
US Stocks 1,104 (108) + 65 Japanese Yen (104) -386 
US Index Pound Sterling 3 +2 
Futures (579) -4 US Dollar 273 + 460 
Stocks 572 -63 Currencies 235 -5 
Bonds (3) d-- 
US Gvt. 
Short 
Term (4) 
Long 
Term (466) 
Japanese 
(5) 1,607 - 380 
Oil 102 +3 
Gold 122 - 28 .

268 The Real-Time Experiment 
repeated warnings, but the market ignored it. I now hear that unit 
I trusts were verbally guaranteeing 9% returns to investors- 
an unsound practice if ever there was one. I should have no- 
ticed these signs of speculative excess, but I failed to pay 
attention. 
My only excuse is that I do not have a permanent presence in 
Japan: my previous foray was fifteen years ago. At that time I was 
a broker advising foreign investors; as a consequence I had the

inside track, and I got out unscathed. Now I am a foreign investor, 
and my fate is typical of the occasional investor from abroad who 
is attracted by a boom: I bought in a rising market, and I shall 
have to selJ in a falling cm; having sean a isge paper profit, I 
shall end up with a real loss. 
t The thesis that attracted me to Japan is no longer valid because 
it was based on excessive liquidity that created a land boom as 
well as a boom in the stock market. Railroad shares, which had

been static since the last boom in 1973, were selling at a fraction 
of their asset value. Railroad companies have a way of accumulat- 
ing assets without showing earnings: since the rate of return on 
commercial real estate is traditionally lower than the interest rate, 
they can shelter their earnings by borrowing money and investing 
it in additional real estate. Thus they enjoy physical growth as 
well as the appreciation of their land values. The fly in the oint-

ment is that shareholders do not get any of the benefits: railroad 
companies are regulated, and if they want any rate increases they 
cannot increase their dividends. But changes are in the wind. The 
National Railroad is being converted to private ownership, and it 
needs to show better earnings in order to be salable to the public. 
Moreover, the pace sf propefiy development needs to be stepped 
up if domestic demand is to be stimulated. This means that rail-

road companies need external financing. As a consequence, both 
the companies and their underwriters have an interest in seeing 
their share prices rise, and most railroad companies have, in fact, 
been issuing bonds with warrants at rising prices. Foreign inves- 
tors were the first to recognize this reflexive thesis, but to validate 
it domestic investors had to follow. That was also beginning to 
happen: at the beginning of the new fiscal year (October I), the

newly formed unit trusts (the ones that were guaranteeing a 9% 
return to investors) pushed real estate-related shares to an all-time 
high on record volume. As it turned out, that was the buying 
climax. The break in New York brought redemptions to Fidelity

Phase 2: July 1986-November 1986 269 
International Investment Trust, which was heavily invested in 
Japanese real estate-related stocks, and they were forced to sell in 
Japan. I was aware of that development at the time, and I intended 
to lighten up on the next rally; but the rally never came, and the 
decline turned into a rout. What I did not realize was the change 
in Japanese government policy in fostering capital exports. I

should have taken my cue from the fact that the yen was stabiliz- 
ing, but I was complacknt. For that, there is no excuse. Now, the 
reflexive thesis has begun to work in reverse. The same factors 
that have punctured the stock market are likely to slow down the 
real estate boom. Although there is going to be a great increase 
in construction, the big increase in land prices is probably be- 
hind us. That is why I have to get out of my positions as best I 
can.

can. 
I must take great care not to compound my error by reacting 
emotionally. The hedges I put on prior to my departure did not 
protect me against the debacle in Japan; in fact they have cost me 
money. I can absorb my Japanese losses; but if I compound them 
with other losses, I could get badly hurt. Yet I cannot stand still, 
either. I must adjust to the changing circumstances. What are 
they? 
First, the yen seems to have topped out, and it would not sur-

prise me if it declined, say, 10%. Capital outflows far exceed the 
surplus on current account, and it is only because a large portion 
of the capital transactions have been hedged that the supply and 
demand for the yen have remained in balance for the last two 
months. As market participants gain confidence that the peak in 
the yen has passed, they may be more willing to hold dollars, 
bringing about a reversal of the tread. The government is unlikely

to allow a decline in the yen to go too far, however, for fear of the 
political consequences. 
I sold all my yen yesterday, and I intend to go short an amount 
equal to about half of my long position in DM. If the DM does not 
weaken in sympathy with the yen, I may even increase my long 
position in DM-half against dollars, half against yen. At the 
same time, I am cutting my long position in gold by half until I 
can see more clearly.

can see more clearly. 
I have also sold some 20% of my Japanese bonds just to give me 
some flexibility, but I think it would be a mistake to liquidate my 
position at the current depressed prices. Yields have risen some 
50-70 basis points. Contrary to previous occasions, the govern-

270 The Real-Time Experiment 
ment is likely to resist a further backing up in interest rates, es- 
I pecially if the stock market continues to decline and the yen 
weakens. 
By the same token, my short position in U.S. government bonds 
makes less sense than it did a few weeks ago: Japanese investors 
are likely to show up in force at the next auction. With the effect 
of the OPEC agreement fully felt by then, I intend to cover my 
short position on that occasion and perhaps even go long.

My U.S. stock portfolio seems reasonably well hedged at pres- 
ent, and I am happy to keep it that way. I am inclined to the short 
side, but I restrain myself lest I compound my mistakes. I have 
less hositaticn in taking profits on Bang Kong real estate shares, 
which are currently at a peak largely as a result of Japanese buy- 
I ing. 
I shall also be happy to sell my oil contracts by the second half 
of November, when they mature. Indeed, I am setting up for sell-

ing short at higher prices by going long in January and short in 
March at practically the same price. I expect the forward discount 
to widen as the price goes up. 
I am now convinced that the "bull market of a lifetime" is 
behind us. There may be occasional flare-ups of speculative activ- 
ity, more unsound than ever, but its main thrust is exhausted. The 
blind confidence, which is an essential ingredient in a mature 
bull market, cannot be reestablished in a hurry. The demise has

been less spectacular than one could have expected from the "bull 
market of a lifetime," although there have been classic climaxes 
in Italy, France, and now Japan. The closest we came to a climax 
in the U.S. has been the momentary rush to redeem mutual funds 
in Septexber. 1 feel prettg fooiish for failing to recognize these 
signs. The fact is that the bull market was cut short by the mone- 
tary authorities before it reached its full extension. They may

lower interest rates yet, but the effect will no longer be the same. 
The bull market was based on the flight from physical to monetary 
assets; further monetary stimulation is likely to engender a flight 
to liquidity, including gold. 
At present, there is a temporary lull: OPEC has been patched 
up, but without a sound foundation; exchange rates have been 
stabilized, but without proper international cooperation; the U.S. 
economy is enjoying a temporary respite before the tax reform

comes into effect; and the stock market is buoyed by deals that 
must be consummated before the end of the year for the same 
reason. What will next year bring?

Phase 2: July 1986-November 1986 271 
SATURDAY, OCTOBER 25,1986 
I managed to sell $750 million worth of yen short before it broke. 
When the DM failed to ,resist the rise in the dollar, I reduced my 
DM position to $750 million. I am now fully hedged, long in DM 
and short in yen. I did not make any money on the maneuver, but 
I avoided giving back nfy profits. 
Oct. 24,1986 
10124186 from 10121 10124186 from 10121 
DM 2.0355 - 2.6 S&P 500 238.26 + 1.0

DM 2.0355 - 2.6 S&P 500 238.26 + 1.0 
# 161.7 - 4.3 U.S. T-Bonds 9529/3~ + 1.3 
E 1.413 - 1.5 Eurodollar 93.99 + .1 
Gold 407.5 - 4,2 Crude Oil 15.02 - 1.1 
Japanese Bonds 101.95 + .6 
QUANTUM. FUND EQUITY $1,455,000,000 
Net Asset VBlue Per Share $9,214 
Change from 10121186 - 2.2% 
Change from 8/16/85 + 110.4% 
Portfolio,Structure (in millions of dollars) 
Net Net 
(2) # (21 
Positions (1) Long Short 10121 Exposure (6) Long Short 10121

Stocks DM-related 792 - 524 
US Stocks i,ii89 (223) 
US Index 
Futures (675) 
Foreign 
Stocks 523 
Bonds (3) 
US Gvt. 
Short 
Term (4) 
Long 
Term (465) 
Japanese 
(5) 1,234 
Oil 99 
Gold 80 - 50 Japanese Yen (735) -631 
Pound Sterling 2 -1 
-96 US Dollar 1,396 + 1,123 
Other 
-49 Currencies 216 - 19

272 The Real-Time Experiment 
t I also tried to unload half my Japanese stock positions on the 
first rally, but I failed: the Japanese broker reneged on his com- 
mitment and took only half the amount he committed for, equal 
to one-eighth of my total exposure. The worst of it is that he now 
knows my intention. This is going to be a bloody business. 
I am beginning to feel uncomfortable with my short positions 
in U.S. government bonds and S&P futures. With the rally in the

dollar, the case against higher interest rates is weakening, and, if 
bonds rally, the shorts in S&P futures may be run in. Everybody 
now expects the Japanese to buy the October government bond 
refunding; therefore, I must act before. There is a 7-year bond 
auction on Tuesday; I must move on that occasion. I can start to 
sell or reduce my long positions on the rally that I expect to follow 
I a successful auction. 
At present, the stock market is dominated by program trading

and portfolio insurance schemes. These schemes are fundamen- 
tally unsound. They virtually assure a loss in exchange for peace 
of mind in a declining market. Only if the decline continued, or 
if the investor had the strength of character to take off the hedge 
in a weak market-which is unlikely, otherwise he would not 
have bought portfolio insurance in the first place-could he real- 
ize a profit. The very expression'"portfo1io insurance" is a false

metaphor because it is based on an analogy with life insurance; 
but death is certain, while a crash is not. 
A rally in the stock market would show up the flaw in portfolio 
insurance; afterward, the market would be in a better position to 
decline. I expect such a decline to follow the next reduction in 
short-term interest rates. In the meantime, the stock market could 
retest its recent high. Other things being equal, there ought to be

a strong year-end rally because of all the tax-induced selling that 
will have preceded it. Of course, the November elections will also 
affect the market, but I do not know how. 
SATURDAY, NOVEMBER 1,1986 
It was a hectic, difficult week. It started out with a collapse in oil 
prices due to the Saudi decision to engage in new "net-back" 
deals. I managed to liquidate most of my crude oil before the 
break, but the drop in oil prices made it more expensive to exe-

cute the rest of my plan. Nevertheless, by Tuesdayafternoon I had 
covered half my stock index short and swung around from being

Phase 2: July 1986-November 1986 273 
' Oct. 31, 1986 
10/31/86 from 10/24 10/31/86 from 10124 
DM 2.0661 - 1.5 S&P 500 243.98 + 2.4 
# 163.25 - 1.0 U.S. T-Bonds 98% + 2.3 
£ 1.4065 - .5 Eurodollar 94.11 +.I 
Gold 403.60 - 1.0 Crude Oil 15.27 i- 1.7 
Japanese Bonds 102.96 + 1.0 
QUANTUM FUND EQUITY $1,469,000,000 
Net Asset Value Per Share $9,296 
Change froni 10124186 + .9% 
Change froni 8/16/85 + IiZ.S% 
Portfolio Structure (in millions of  doll^^)

Portfolio Structure (in millions of  doll^^) 
, Net Net 
(2) (2) 
Positions (1) Long Shod 10124 Exposure (6) Long Short 10124 
Stocks DM-related 1,280 + 488 
US Stocks 1,015 (99) - 30 Japanese Yen (955) -220 
US Index Pound Sterling 3 + 1 
Futures (3273 + 348 US Dollar 1,141 - 255 
Stocks 460 -63 Currencies 201 - 15 
Bonds (3) ,- 
US Gvt. 
Short 
Term (4) 
Long 
Term 1,073 + 1,538 
Japanese 
(5) 1,232 -2 
Commodities

Japanese 
Oil (28) -127 
Gold 79 -1 
$500 million short in government bonds to an $800 million long 
position. But the 7-year auction did not go well-I must have 
been the biggest buyer-and by Tuesday night I was losing on all 
fronts. Then came two unexpected developments: the dismissal 
of Sheik Yamani as Saudi oil minister and the indication that the 
Japanese discount rate will be lowered. Suddenly, my position

2 74 The Real-Time Experiment 
t looked much brighter. I used the opportunity to reduce my hold- 
ings in Japanese real estate-related stocks and increased my hold- 
ings in U.S. government bonds to $1200 million. I also increased 
my cross position-long DM, short yen-to $1 billion. I have 
bought an additional $250 million worth of DM, giving me a mod- 
est net short position in the dollar. 
My additional purchase of U.S. bonds turned out to be badly

timed because oil rallied sharply, following a call by the new 
Saudi oil minister for an emergency meeting of the OPEC pricing 
committee. The situation is extremely confused, but the prevail- 
ing opinion is that the change represents a victory for Iran, and 
the Saudis will raise prices even if it means selling less oil. I take 
a different view, but I have not yet developed a high degree of 
t conviction in it. In my opinion, the Saudis will publicly posture

for fixing the oil price at $18, but they will not abandon their net- 
back deals and they will continue to play hardball in fighting for 
market share. Since it is impossible to maintain oil at $18 without 
reducing production all around, it is probable that negotiations 
will break down, and there will be another round in the price 
war. The Saudis have to be careful, however, not to anger Iran. I 
have started to short oil again, but only in small quantities be-

cause I cannot afford to take much risk. I am already exposed 
enough in bonds. If my bond play works out, I may become more 
courageous in oil-if it is not too late. 
In the last two days of the week, a number of stronger economic 
figures were released, weakening my strategic position. The dollar 
rallied, but the yen/DM cross position has been working in my 
favor (see chart on p. 275), especially on Friday, after the joint 
Japanese-American statement was released. The statement con-

firms the thesis on which the cross position is based: whatever 
pressure develops against the dollar, it will be concentrated on 
European currencies-and possibly gold. If, however, the U.S. 
economy turns out to be stronger than I expected, the DM may 
decline even more than the yen because it has greater volatility. 
Thus, the position is not without risk; but I cannot see the dollar 
getting much stronger. My main risk is in bonds and in what has

turned into a cross position: long bonds, short stock indexes. I am 
not unduly worried about the economic statistics because they 
merely confirm a temporary pickup prior to the tax changes; I am 
willing to take a view on oil; my main worry is the election next 
Tuesday, whose impact I cannot evaluate. The trouble is that my

Phase 2: July 1986-November 1986 275 
tolerance for losses has been reduced by the losses I have already 
sustained, both in my niacro manipulations-the hedge I took on 
prior to my trip to China turned out to be quite costly-and in my 
investment portfolio, which continues to unravel. As a conse- 
quence, I feel nervous and somewhat overexposed. 
YEN vs. DEUTSCHE MARK AND YEN vs. DOLLAR 
EXCHANW RATES 
Jan 82 Jan 83 Jan 86 I 10/27/86-10129/86 
sold $250 mm Yen at 160.28

sold $250 mm Yen at 160.28 
bought $250 mm DM at 2.0217 
cross rate 79.28 
10/21/86-11/3/86 
sold $786 mm Yen at 155.84 
bought $50 mm Dust 1.9931 
implied cross rate 75.94 
SATURDAY, NOVEMBER 8,1986 
The gamble on the governlrrent bond auction did not work out: an 
initial profit turned into a loss. I cut my position to limit the loss. 
The news on oil has been contradictory and I decided to with- 
draw to the sidelines; I also withdrew from gold at the same time.

All I have now is a cross position-long bonds, short stock in- 
dexes-which I regard as a temporary expedient; a long position 
in Japanese bonds, which I may gradually Iiquidate or partially 
switch to German bonds; and my currency positions, which seem 
soundly based. 
Most of my recent macro moves turned sour; only the decision 
to short the yen has saved the day. I can apply the profit on the 
yen either to offset the losses on the other moves or to protect my

2 76 The Real-Time Experiment 
Nov. 7,1986 
11/7/86 from 10/31 11/7/86 from 10/31 
DM 2.0610 + .2 S&P 500 245.77 + .7 
U 163.00 + .2 U.S. T-Bonds 96lY32 - 1.8 
£ 1.4310 + 1.7 Eurodollar 93.92 - .2 
Gold 388.60 - 3.7 Crude Oil 15.17 - .7 
Japanese Bonds 103.09 + .1 
QUANTUM FUND EQUITY $1,461,000,000 
Net Asset Value Per Share $9,320 
Change from 10/31/86 + .3% 
Change from 8/16/85 + a12.e% 
Net Net 

Net Net 
(2) (2) 
Positions (1) Long Short 10/31 Exposure (6) Long Short 10/31 
Stocks DM-related 1,334 + 54 
US Stocks 1,022 (71) ' + 35 Japanese Yen (956) -1 
US Index Pound Sterling 7 +4 
Futures (544) -217 US Dollar 1,076 - 65 
Stocks 436 -24 Currencies 201 0 
Bonds (3) 
US Gvt. 
Short 
Term (4) 
Long 
Term 750 - 323 
Japanese 
(5) 983 - 249 
Oil + 28 
Gold 41 - 38

Oil + 28 
Gold 41 - 38 
tions failed to protect me against a deterioration in my investment 
positions and the asset value of the Fund has declined. 
This is an opportune moment to end the real-time experiment 
because it is gradually deteriorating into a record of my day-to- 
day trading activity. It is not without interest-I follow a stochas- 
tic, trial-and-error method that seems to produce positive results

Phase 2: July 1986-November 1986 277 
on balance-but it is rather messy because of the prevalence of 
errors, and it takes us rather far afield from the original purpose 
of the experiment. I could justify taking the readers along the 
torturous course of my mega-manipulations for a while-if for no 
other reason than to give them a more balanced picture than Phase 
1 alone would have dohe-but I must draw the line somewhere 
and return to the original question, namely, the resolution of the

contradictions inherent'in the Imperial Circle. Incidentally, I am 
beginning to worry that the process of recording my thoughts for 
public consumption may interfere with my ability to acknowl- 
edge and correct mistakes promptly because doing so makes the 
record sven messier. I ern thinking of the hedge I put ~)n pricr to 
my trip to China, which turned out to be so costly.

RELATIVE TO MARKETS. 
Phase Two: 7/21 to 11/7 1986 
30% 
25% 
20% 
15% 
10% 
5% 
0% 
-5% 
-10% 
-15% 
-20% 
Juf 21 Aug4 ~ugi8 Sept 1 Sept 15 Sep29 Oct 13 Oct 27 
Jul 21 Aug4 AU~ 18 Sept 1 Sept 15 Sep 29 Oct 13 Oct 27 
Notes: 
(2) EAFE is Morgan Stanley's Capital International Index in U.S. dollars for European, Australian,

(3) The Oil and the Government Bond prices are the closing prices of the nearest futurcs contracts. 

Jul 21 Aug4 Aug 18 Sept 1 Scpt 15 Sep 29 Oct 13 Oct 27 
I NET CURRENCY EXPOSURE 
1 Aug 15 Aug29 12 ~eb26 ' 0ct 10 ' 0et 24 ' N& 7 
Deutsche Mark Yen Pound Sterhng 0 Fmsh Other 0 US. Dollar 
Notes: 
[?I Prices in U.S. dollars shown as percent change over the first day shown. New York closing 
(2) Net currency exposure includes stock, bonds, futures, forwards, cash, and margins, and equals

- Standard and Poor's 500 lndcx - Fund's Nct Assct Valuc Per Sham 
1.8 
1.6 
1.4 
1.2 
1.0 
v: 0.8 
0.6 s 0.4 
ii 0.2 
V) ", 0.0 = -0.2 -0.4 
-0.6 
-0.8 
-1.0 -1.2 
J 

- U.S. Stocks ----- US. Stock Mukct lndcx Futums 
Note: 
4-

- European Stock Markets Index (in U.S. dollars) 
7 Japanese Stock Market Index (in U.S. dollars) 
"""'1""""'1.,,,,,,,,IrIIIIIIIIIII..,,,,.l..,,,,.,,p,,.,,,r.,,,,~,,.,, 
July 21 Aug4 Aug 18 Sep 1 Sep 15 Sep29 Oct 13 Oct 27 
B Continental European Japanese Brihsh 

Notes: 
(1) Total foreign stock market profits and losses include foreign exchangc gains or losses on 
forcign stock positions. 
[2) Far Eastcrn positions include Hong Kong. Korea. Taiwan, Australia. and ~m"and.

Phase Two: 7/21 to 11 /7 1986 
30% 
25% 
20% 
15% 
10% 
5% 
0% 
-5% 
-10% 
-15% 
-20% 
jul 21 Aug4 Aug 18 Sept 1 !hpt 15 - Sep 28 Od 13 Od 27 - Oil - Cold 
Jul 21 Aug4 Aug 18 Sep 1 Sap 15 Sep 29 Oct 13 Od 27 
Oil II Cold

10 
5 
0 
-5 !j -10 : -1s 
V) = -20 
-2s 
-30 
-3s - Oil - 'cold - Totrl Commodity PIL

9% 
8% 
7% 
6% 
5% 
4% 
3% 
2% 
1% 
0% 
-1% 
-2% 
-3% 
-4 % 
-5% 
-6% 
-7% ,,-. . --.--, -..-... --.. '- -.-- ' . , I I I -8% . Y I 
- U.S. Treasury BiLl Futures --- U.S. Government Bond Futures 
.. .. . . . . . . . . . . . Japanese Government Bond Futures 
4.61,1111~~~~~~~1 
Aug 1 Aug15 Aug29 Sep 12 Sep26 Oct 10 Oct24 Nov7 
U.S. Short Term Bonds U.S Long Term &mds 
CZZ3 Japanese Long Term Bonds

Notes: 
Futures. and Treasury Notes up to two years to maturity. A 
(2) All U.S. Government Bonds are reduced to a common denominator of 30-year Govcrnmcnt 
$100 million in face value of 4-year Treasury Notes are equivalent to $28.5 million in market

(3) Japanese Government Bond Futures have considerably less volatility than U.S. Governmcnt 
Bonds. For instance, as of June 30, 1386, Or00 million in face value of Japanese Government 
Bonds had the same volatility as roughly $66.2 million in 30-year U.S. Govcrnmcnt Bonds. We 

THE CONCLUSION: NOVEMBER 1986 
\ 
The "bull market of a lifetime" came to a premature end. I am not 
ruling out the possibility of another bull market, but that would 
be a distinct development. * 
The very fact that the "bull market of a lifetime" was aborted 
provides a valuable insight into the overall situation. It is not the 
only sequence that has come to a premature end before it could 
have wreaked havoc. The Imperial Circle was another. Once we

start looking for them, other examples abound. OPEC nearly came 
apart, but when the chasm opened the members pulled back from 
the brink. The same is true of international lending: I have ana- 
lyzed collective lending as a system born of emergency which 
needs emergency conditions to survive and is so constructed as 
to generate the emergency conditions that are needed to keep it in 
existence. In the case of freely fluctuating exchange rates, I have

argued that they are cumulatively unstable, but the Group of Five 
intervened before their destabilizing effect would have become 
intolerable, and we have turned to a system of "dirty float." 
Looked at in this light, the U.S. budget deficit becomes another 
case in point. I had thought that 1985 would see the culmination 
of deficit financing and, with or without Gramm-Rudman, we 
would begin to see a gradual improvement. I must now revise this

view. We did, in fact, reach a climax in 1985, but the turning 
point did not constitute a departure in the opposite direction. 
When the crisis receded, so did our resolution to deal with it. The 
* P.S., January 1987: I spoke too soon. But if markets become euphoric, the 
"brink" model I shall outline in this chapter becomes all the more relevant. 
288

The Conclusion: November 1986 289 
budget deficit remains almost undiminished and it may easily 
swell to a crisis point again. 
We may generalize from these instances and formulate the hy- 
pothesis that we live in a financial system that tends to go to the 
brink and then recoil.' This hypothesis fits in well with the ten- 
dency of our economj to flirt with recession and then to rebound 
without gathering real strength. There is a logical connection be-

tween the two tendebcies: it is the danger of a recession that 
prompts remedial action. Although we can expect the system to 
recoil from the brink every time it gets there, we cannot be sure; 
and the more confident we become, the greater is the danger that 
it will ~ot. lire could, ca!! this a system of self-defeating proph- 
ecies, 
The system I am describing bears a certain similarity to the 
adjustment process in classical economic theory: after all, self-

defeating prophecies are a kind of self-correcting mechanism. But 
there are some vital differences. First, the classical adjustment 
process tends toward equilibrium; in the system under consider- 
ation there is no such tendency. Second, the arrangement de- 
scribed here subordinates the real economy to the vagaries of the 
financial system. There is a flight from fixed assets to financial 
ones. The fortunes of particular industries rise and fall with ex-

change rates but, on balance, it is not unfair to say that the real 
economy is being sacrificed to keep the financial economy going. 
This fundamental instability creates tensions thatpay find polit- 
ical expression. The main dangers are protectionism at home and 
debt repudiation in the debtor countries. That is what makes the 
system so precarious. 
It has not always been so. The first time we went tu the brisk 
was in 1982, although the situation had been getting progressively

more unstable ever since the breakdown of fixed exchange rates 
in 1973-and that breakdown itself was a sign of instability. 
There seems to be a qualitative difference between conditions 
prior to 1982 and those afterward. Prior to 1982 the situation may 
have been deteriorating but the system was essentially viable; that 
is why it was allowed to disintegrate. Since 1982, the system has 
been basically unsound, and it has been kept together only by the

threat of a breakdown. Could it be reconstituted on a sounder 
basis? I shall consider that question in Chapter 18. Here I must 
reconcile the system I am describing with the concept of a credit 
and regulatory cycle. 
The fact that the normal, cyclical pattern has been broken was

290 The Real-Time Experiment 
clear to me from the outset; I emphasized that we were passing ' through uncharted territory. But I failed to understand the impli- 
cations of this fact; I tried to navigate through uncharted territory 
using the same old cyclical chart. No wonder I kept going astray! 
First I was surprised by the emergence of the Imperial Circle; then 
in the course of the experiment I was surprised by the premature

demise of the Golden Age of Capitalism. In Phase 2 of the experi- 
ment I was finally forced to realize that the boornhust pattern is 
inappropriate to the current situation. We need a different model. 
The image that comes to mind is that of a needle stuck in a groove. 
But we need to be somewhat more analytical about it. 
The normal. course of the cr~dit cycle has been arrested by the 
intervention of the authorities. Thus we must look at their behav-

+ ior for a clue. When disaster threatens, they pull together; when 
the danger recedes, they pull apart. This is the mechanism that 
lies at the heart of the "going-to-the-brink" phenomenon. The 
collective system of lending provides the paradigm, but the other 
instances I have cited-the exchange rate system, the budget def- 
icit, OPEC, even a 1929-style bull market-also fit the pattern. 
The mechanism comes into play only when a bust w~uld have

catastrophic consequences; that is why it has been operating only 
since 1982. Sometimes it is effective before the climax is reached, 
as in the exchange rate system and the "bull market of a lifetime"; 
sometimes only afterward, as in the international debt crisis and 
in OPEC. 
Why does the intervention of the authorities fail to produce a 
lasting reversal of the trend? Two factors are at play. First, past 
excesses are not liquidated but merely contained; therefore they

continue to fester. This is particularly true of the accumulation of 
bad debt. Second, an orderly correction or containment may not 
be sufficient to bring about a decisive reversal in the prevailing 
bias. For instance, the banks continued on their expansionary 
path after 1982; the spirit of a bull market could be easily rekin- 
dled, especially in the U.S., where the damage to confidence has 
not been severe; and in the case of OPEC it remains to be seen

whether the experience of 1986 was sufficient to generate the 
cohesion necessary to prevent a recurrence. 
The impact of these two factors varies from case to case. As a 
consequence, we do not get a clear-cut cyclical pattern but some- 
thing much more indecisive and variegated: some trends are gen- 
uinely reversed; others go into temporary remission; yet others

fie Conclusion: November 1986 291 
manifest themselves in different forms. For instance, when bank 
regulation was tightened in 1984, many of the risks were trans- 
ferred to the financial markets. 
How is it all going lo end? In theory, we could keep going to 
the brink indefinitely, ,but since nothing lasts for ever, somehow 
we are going to get odt of the groove. It could happen in one of 
two ways: the system could break down as the result of an acci-

dent, or we could gradually work our way out of all the excesses 
and stop going to the brink. As we bump along from crisis to 
crisis, many of the excesses do get corrected. The banks are less 
exposed then they were in 1982; many structural changes have 
occurred in the deStor countries; both the hudgct and tho trade 
deficits of the United States seem to have culminated; and a 1929- 
style boom seems to have come to a premature end. On the other

hand, financial assets continue to accumulate at a pace which 
outstrips the creation of "real" wealth, and this disparity is one 
of the excesses that needs to be corrected. 
A positive resolution would require greater stability in ex- 
change rates, a continued decline in real interest rates, and an 
appreciation in stock prices to a point where investment in "real" 
assets would offer greater returns than would the purchase of

securities. It is difficult to see how such a point could be reached 
as long as the federal government continues to borrow at the pres- 
ent rate. A negative resolution would involve increasing financial 
instability, protectionism, a worldwide recessioa, and a flight 
from financial to liquid assets. I cannot predict which outcome is 
more likely. 
It can be seen that the model I arrived at has even less predictive 
power than the boomhust model. The boomlbust model did tit

least indicate the direction and sequence of events; the "brink" 
model does not even do that, because a climax is not necessarily 
followed by a trend reversal. Nevertheless, the model is not with- 
out some explanatory power. 
The question posed at the beginning of the experiment-what 
is the eventual outcome-must remain unanswered. In that re- 
spect, Phase 2 of the experiment ends with a whimper rather than 
a bang. But there is another, related, question that admits a more

definite answer: which brink are we going to next? A correct an- 
swer can help convert speculation from a random walk to a prof- 
itable exercise. 
Clearly, the next brink is protectionism. With a Democratic

292 The Real-Time Experiment 
I Congress, some action is inevitable. Its severity will be greatly 
influenced by the pace of economic activity. If the experience of 
the last five years is any guide, protectionist pressures will be 
accommodated short of allowing the system to disintegrate. The 
administration has already indicated that it is willing to cooperate 
with Congress to that end. Nineteen eighty-seven may well see 
some measure of protectionism combined with some measure of

debt relief. 
The ultimate challenge to the system is a worldwide recession, 
and the first half of 1987 will be a severe test in that regard. Some 
of the economic activity in the final quarter of 1986 will have 
been borrowed from 1387 because of the Tax Reform Act of 1986. 
Undoubtedly, tax reform will help to eliminate distortions from 
I the economy; but it is always when past excesses are corrected 
that their negative effect is most severely felt. The much-awaited

retrenchment in consumer spending may finally be upon us. 
Moreover, the Japanese economy is weak, and Germany's is weak- 
ening. A worldwide recession coupled with protectionist legisla- 
tion could sweep us over the brink. 
What are the chances of a recession? I find the argument that a 
recession must be close at hand just because four years have 
elapsed since the last one quite unconvincing. In an expansionary 
phase, recessions are induced by the monetary authorities in their

attempt to cool off an overheated economy. But we are not in an 
expansionary phase, and there is no overheating. A more convinc- 
ing case can be made by arguing that we are in a phase of credit 
contraction in which the economy would naturally slip into a 
recession unless it is actively stimulated. It is difficult to see 
where the stimulation could come from. Still, the monetary au- 
thorities have at least one more round of interest rate reductions

in their armory; the decline in the dollar may finally begin to 
make its effect felt on the trade balance; and the prospect of higher 
oil prices may encourage inventory accumulation. Instead of a 
recession, we may just have a few more years of substandard 
growth ahead of us. 
My analysis is inconclusive, to say the least. What will happen 
in the financial markets in 1987? That will be the subject of an 
ongoing real-time experiment.

The Conclusion: November 1986 293 
P.S., DECEMBER 29, 1986 
Two major events have occurred since the conclusion of the ex- 
periment: the Boesky affair, and the OPEC agreement. Both have 
bullish implications. The Boesky affair constitutes a dramatic 
turning point in the speculative excesses of mergermania. In con- 
trast to other turning pqints, it does not endanger the system; that 
is why it will be allowed to be played out in full. It will not bring

corporate restructuring to a halt, but it will slow it down. The 
flow of funds into junk bonds will be reversed, greatly increasing 
the risk premiums they must carry. The effect will be to ease the 
demand for credit and to nudge the Federa4 Reserere toward easing 
the money supply. All these influences are positive for govern- 
ment bonds and, indirectly, for blue chips. It is noteworthy that 
the bond markets have shrugged off the news of an OPEC agree-

ment. Higher oil prices are likely to encourage inventory accu- 
mulation, moderating downward pressures on the economy, 
especially in the first quarter of 1987. 
I approach the year's end fairly fully invested in both bonds 
and stocks and do not intend to take my leave until after a dis- 
count-rate cut. The major cloud on the horizon is a renewed 
weakness of the dollar. 
P.P.S., FEBRUARY 1987 
-x$- 
Obviously, I spoke too soon when I said that the "bull market of

our lifetime" came to a premature end. The stock market broke 
out of its doldrums immediately after the turn of the year and 
attained new high ground very soon thereafter. tAJE,at T considered 
to be the end of the bull market turned out to be merely a tempo- 
rary interruption that was due to selling pressures engendered by 
the abolition of the preferential tax treatment of long-term capital 
gains. As soon as the pressure lifted, the market took off.

The current advance qualifies as the third wave in the bull 
market that began in August 1982. It has many of the same fea- 
tures as the second wave that began in October 1985 but in some 
respects it is faster and wilder, as befits a more advanced stage. 
For instance, the first buying climax came sooner than last time 
and caused sharper price fluctuations (6% in the S&P futures, 
versus only 4.8% in 1986). The parallel with the bull market that

led up to the crash of 1929 is widely recognized. The charts of the

294 The Real-Time Experiment 
, Dow Jones averages, when superimposed upon each other, show 
an uncanny similarity (see chart). Robert Prechter, a technician 
who bases his predictions on the Elliott wave theory, has become 
the prophet of our time whose predictions can move the market 
-indeed, he is largely responsible for the deviation from the 
pattern of 1928 that occurred on January 23,1987. 
Equally significant is the fact that the Japanese stock market has

also recovered from the nasty break it suffered in October 1986 
and reached new highs recently. How do these developments af- 
fect the validity and relevance of my conclusions? 
The revival of the bull market fits in well with the "brink" 
model I developed at the end of the experiment. It is a distin- 
guishing feature of the model that we may keep going to the same 
I brink instead of experiencing a decisive trend reversal. 
The ease with which the model can accommodate the revival

of the bull market confirms my assertion that it has next to no 
predictive value. It merely offers a conceptual framework for un- 
derstanding the course of events. The specific predictions must 
THE DOW IN THE EIGHTIES AND TWENTIES 
3200 , , 400 
1985 1986 1987 1988 1989 1990 1991 
0 
1825 1926 1927 1928 1930 1931 1932 1933 
Courtesy Tudor Investment Corp.

The Conclusion: November 1986 295 
be formulated by the user; the model provides only a general hy- 
pothesis about prevailing market expectations-namely, that they 
are likely to prove self-defeating. 
The user's own prediction may turn out to be false; if so, it is 
up to him to correct it. When he is a participant in financial 
markets, he has a stronb financial incentive to do so. In the case 
of financial advisers, academics, or politicians, it may be more

advantageous to obfuschte one's mistakes than to admit them. The 
model can also be useful in that regard. Indeed, it could legiti- 
mately be asked whether I have tried to cover up my inability to 
predict the course of events by creating the "brink" model. If so, 
I shall pay a heavy price, because I intend to use the model in 
dealing with the renewed bull market. That is to say, I operate on 
the assumption that we are in a 1929-type bull market which will,

however, abort long before it reaches the lofty heights of 1929. 
Clearly, there is a loag way to go before the internal dynamics 
-or, more accurately, dialectics-of the market render it ripe for 
a reversal. If anything, the correction in the second half of 1986, 
coupled with the further decline of the dollar, has extended the 
"natural" life span of the boom. If it is to be aborted again, the 
causes will have to be external. What these external constraints

are has been amply discussed: a recession, coupled with protec- 
tionism, would be more dangerous than a buoyant economy. 
Eventually, the monetary authorities are unlikely to tolerate a 
runaway boom-but that point is a long way swab-at least as far 
as the U.S. stock market is concerned. 
Not so in Japan. The valuation of Japanese stocks has long 
ceased to bear any relevance to the fundamentals. Pricelearnings 
mu:tiples are excessive even h relation to the low and declining

interest rates that prevail in Japan. Moreover, the reported earn- 
ings of many companies are artificially inflated by profits from 
stock transactions. The outlook for industrial profits is poor, and 
companies use their surplus cash to speculate in the stock market. 
Specialized funds have been set up to attract corporate investors, 
and they have been illegally promising a guaranteed minimum 
return. A governmental investigation of these so-called "tokkin

funds" received a lot of publicity at the time of the stock market 
break of October 1986. Nevertheless, the market has recovered its 
poise and reached new highs early in 1987. How far can the boom 
go? Just as Italy was the market to watch for impending trouble in 
1986, in 1987 it is Japan.

296 The Real-Time Experiment 
The Japanese stock market is fueled by liquidity and the liquid- ' ity is generated by the combination of a weak economy and a 
strong yen. When either Japanese or non-Japanese holders of dol- 
lars convert them into yen, some of those yen find their way into 
the stock market. The tendency is particularly strong when the 
yen are supplied by the central bank in an endeavor to keep the 
exchange rate from rising. When the central bank is not involved,

there is at least a chance that the sellers of yen sell, or fail to buy, 
Japanese stocks in order to acquire assets denominated in dollars. 
The Japanese government has engaged in a campaign to encour- 
age investment abroad and, on the whole, it has been very suc- 
cessh!: capitc;! outflows consistently exceed the trade surplus. 
The yen continues to strengthen only because of an inflow of 
1 foreign capital and hedging by Japanese investors. Once market

participants gain conviction that the trend is changing, they re- 
duce their hedging, and the yen falls of its own accord. That is 
what happened last October, although the break in the stock mar- 
ket preceded the decline of the yen. It is likely to happen again. 
Since the end of the year, the upward pressure on the yen has 
built up again and the stock market boom gained a new lease on 
life. When the pressure abates, involuntary selling by the Bank of

Japan will be replaced by voluntary selling by holders of yen. 
That is when the pool .of liquidity will spring a leak. Given the 
inflated level of stocks prices, a decline could easily turn into a 
rout. 
There is a noteworthy similarity between the position of Japan 
today and that of the United States in the 1920s: it is emerging as 
the leading economic power and its stock market is less seasoned 
than that of the mature economies. But that is where the simflarity

ends. The Japanese authorities have a tradition of intervention 
and a firm grip on the participants in financial markets. Once 
before, in 1965, when the stock market collapsed, the government 
set up a corporation to buy, and hold, shares dumped on the 
market by distressed holders. Nineteen twenty-nine is not likely 
to repeat itself, even in Japan. 
The initial impact of a decline in the Japanese stock market 
could well be positive for other markets because it is likely to be

associated with a wholesale movement of funds from the Japanese 
to other stock markets. But if the decline turns into a rout, it is 
bound to send a shiver through the world.

THE SCOPE FOR FINANCIAL ALCHEMY: 
AN EVALUATION OF THE EXPERIMENT * 
The real-time experiment has turned out quite differently from 
what I had expected; moveover, the results of the second phase 
are quite different from those of the first: the evaluation I wrote in 
June 1986 had to be rewritten in light of what has happened since. 
Phase 1 shows my approach at work when it is successful, Phase 
2 when it is not. This makes the task of evaluation more complex;

but it will also render the judgment more complete. 
In evaluating my approach we must distinguish between its 
ability to produce profits in financial markets and its ability to 
predict the future course of events. The fact that theYIistinction is 
necessary has far-reaching implications, which will be explored 
in the course of this chapter and the next one. 
First, as to the financial results. Phase 1 coincided with the 
most prosperous period of my Fund. In the eleven months be-

tween the inception of the experiment and the end of the control 
period, Quantum Fund shares appreciated by 126°/0, as against 
27% for the S&P index, 30% for Treasury bond futures, 23% for 
the DM, and 34% for the yen. Admittedly, these were prosperous 
times for most investors, even for those who were on the wrong 
side of the currency trend; but few did as well as my Fund. Lever- 
age is only part of the explanation, because leverage works in both

directions: one has to be on the right side of the market to benefit 
from it. 
Even if we make allowances for an element of coincidence, 
* Written in June 1986; revised in December 1986.

300 Evaluation 
there can be no doubt that the process of formulating and testing 
I hypotheses made a positive contribution to the results. 
By contrast, Phase 2 shows a loss. Between July 21, 1986, and 
the end of the year Quantum Fund shares declined by 2% as 
against a 2% rise for the S&P index, a 2% fall for the Treasury 
bond futures, a 1% rise for the Japanese government bond futures, 
and a 5% rise for the Japanese stock index. The DM rose by lo0$,,

the yen fell by 2%, gold rose by 14%, and oil rose by 40%. Putting 
both phases into the context of my entire performance, the results 
can be considered satisfactory. 
The record shows that my trading was far from flawless even in 
Phase 1. I was tc~o lsts in buying bonds and too early in selling 
them-although I had the courage to reestablish the position at a 
4 much higher price. I was also rather late in recognizing the "bull

market of our lifetime" in stocks. My trading in currencies was 
the best: the insight that the level of risk had been reduced by the 
Plaza meeting of the Group of Five was highly rewarding. 
Phase 2 is dominated by one major mistake: my reluctance to 
recognize that the "bull market of a lifetime" had run its course 
before it had truly earned its name. The consequences were par- 
ticularly painful in Japan where I was participating in a classic

boondbust sequence and failed to get out in time. Once commit- 
ted, the mistake was difficult to rectify; but at least the analytical 
framework made me aware of what I was up against. A method 
that produces outstanding results during good periods and 
helps to contain losses during bad ones must be declared a suc- 
cess. 
Class A Shares 
% Change 
Net from 
Asset Value Preceding 
Year Ended Per Share Year Size of Fund 
Dec. 31,1984 $3,057.79 $488,998,187

Dec. 31,1984 $3,057.79 $488,998,187 
Dec. 31,1985 $6,760.59 + 121.1% $1,003,502,000 
Dec. 31,1986 $9,699.41 + 43.5% $1,567,109,000* 
Mar. 31,1987 $12,554.16 + 29.4% $2,075,679,000* 
a ion: Compounded annual appreci t' 
1969-1986: + 35.4% 
* Unaudited. 1984-1986: + 78.1%

The Scope for Financial AIchemy 301 
My financial success stands in stark contrast with my ability to 
forecast events. In this context, we must distinguish between 
events in financial markets and events in the real world. Events 
in financial markets determine financial success; events in the 
real world are relevant, only in evaluating the scientific merit of 
my approach. I 
Even in predicting vancia1 markets my record is less than

impressive: the best that can be said for it is that my theoretical 
framework enables me to understand the significance of events as 
they unfold-although the record is less than spotless. One 
would expect a successful method to yield firm predictions; but 
all my forecasts are extremely tentative a;nd subject to constant 
revision in the light of market developments. Occasionally I de- 
velop some conviction and, when I do, the payoff can be substan-

tial; but even then, there is an ever-present danger that the course 
of events fails to correspond to my expectations. The concept of 
the "bull market of a liftime" is a case in point: it was highly 
rewarding in Phase 1 but it became more of a hindrance than a 
help in Phase 2. My aiproach works not by making valid predic- 
tions but by allowing me to correct false ones. 
With regard to events in the real world, my record is downright

dismal. The outstanding feature of my predictions is that I keep 
on expecting developments that do not materialize. During the 
real-time experiment I often envisioned a recession that was just 
around the corner, but it never occurred; at the imption of the 
experiment I was contemplating a reversal of the Imperial Circle 
that was avoided only by the deus ex machina of the Plaza agree- 
ment of the Group of Five. Going further back, a collapse of the

banking system has never been far from my thoughts since 1982. 
Similarly, I expected the collapse in oil prices to be followed by 
a tax on imported oil, of which there is no sign. To be fair, there 
were some developments that I anticipated correctly-the col- 
lapse in oil prices was one and the willingness of the Japanese to 
finance our budget deficit was another. Although I did not antici- 
pate the Group of Five meeting at the Plaza Hotel, it fitted my

framework perfectly and I responded to it correctly. 
How can financial success and predictive failure be reconciled? 
That is the question I shall address in this chapter. But before I 
do so, I must remind the reader why it arises in the first place. If 
this were a scientific experiment, my financial success would 
serve as evidence of the validity of the hypotheses on which my 
decisions were based. But the experiment does not qualify as a

302 Evaluation 
scientific one. I need to raise only two considerations to make 
4 this point: one personal and the other pertaining to the subject 
matter. 
My decision-making process was greatly influenced by personal 
factors such as my presence or absence from the office, and the 
real-time experiment itself was an important personal factor. The 
fact that the monetary results served as a possible criterion of the 
validity of my ideas made me try harder than I would have oth-

erwise. This is borne out by the fact that my understanding was 
much hazier and my moves in the market more tentative during 
the control period than they were at the height of the experiment. 
Such haziness is quite common; it is the sharp focus that I man- 
aged to attain in the course of the experiment that is rather excep- 
t tional. I was greatly helped by the discipline of having to write 
down my thoughts. My arguments may not strike the reader as

particularly well organized, but they are certainly more consistent 
than they would have been if I had not taken the trouble to for- 
mulate them in writing. I was also inspired by the fact that I was 
able to combine the two great abiding interests in my life: philo- 
sophical speculation and speculation in financial markets. Both 
seemed to benefit from the combination: together, they engaged 
me more than either one on its own.

me more than either one on its own. 
The other consideration has to do with external events. Phase 1 
happened to coincide with a moment in history when the author- 
ities tried to assert their leadership: they cooperated first in push- 
ing down the dollar and then in pushing down interest rates. The 
theoretical framework I was using was particularly well suited 
for dealing with these developments. After all, the interplay be- 
tween markets and regulators is one of the main themes in the

concept of a regulatory and credit cycle. My theoretical frame- 
work might have proven much less helpful at other moments in 
history. 
For instance, I recall the time, in 1981-82, when the Federal 
Reserve sought to control the quantity of money and allowed 
market forces to set interest rates. The market for government 
bonds, and to a lesser extent for stocks and currencies, became 
like a casino, and my approach of formulating hypotheses and

testing them against the market became worse than useless: by the 
time I recognized a market trend and formulated a hypothesis to 
explain it, the trend had already changed and I had to find a new 
hypothesis. The result was that I was always lagging behind the

The Scope for Financial Alchemy 303 
market and kept on getting whipsawed until I abandoned the 
hopeless struggle and delegated the task of gambling in govern- 
ment bond futures to someone more qualified. I found a com- 
puter-based speculator, Victor Niederhofer, who had developed a 
system using the assurn;ption that the market is a casino. He op- 
erated successfully until the international debt crisis of 1982 
changed the nature of tqe game. He had the rare fortitude to close

the account before he had lost all the money he had made for me 
previously. I could argue that an approach which allows me to 
recognize when it does not work is a valid approach; still, it is 
somehow more convincing to demonstrate it at a juncture when 
it does work. 
These two considerations go a long way toward explaining my 
financial success during the experiment. They also serve to dis- 
qualify it as a scientific experiment. First, the fact that an experi-

ment is conducted is not supposed to influence the outcome; in 
my case it did. Second, scientific theories are supposed to be 
universally valid, while mine seems to operate only intermit- 
tently. But the divergence from a sceintific experiment goes much 
deeper. I have never claimed scientific status for my theoretical 
framework. On the contrary, I have argued that reflexive processes 
cannot be predicted by scientific method, and the real-time exper-

iment was a deliberate attempt to explore an alternative method. 
To bring the point home, I have described the alternative method 
as alchemy. Scientific method seeks to understandittrings as they 
are, while alchemy seeks to bring about a desired state of affairs. 
To put it another way, the primary objective of science is the truth 
-that of alchemy, operational success. 
In the sphere of natural phenomena, there is no distinction

between the two objectives. Nature obeys laws that operate inde- 
pendently of whether they are understood or not; the only way 
man can bend nature to his will is by understanding and applying 
these laws. That is why alchemy has failed and natural science 
reigns supreme. 
But social phenomena are different: they have thinking partici- 
pants. Events do not obey laws that operate independently of 
what anybody thinks. On the contrary, the participants' thinking

is an integral part of the subject matter. This creates an opening 
for alchemy that was absent in the sphere of natural science. Op- 
erational success can be achieved without attaining scientific 
knowledge. By the same token, scientific method is rendered just

304 Evaluation 
as ineffectual in dealing with social events as alchemy was in 
I altering the character of natural substances. I shall revert to the 
predicament of the social sciences in the next chapter; here I want 
to explore the scope for alchemy. 
The real-time experiment shows that my approach is more suc- 
cessful in dealing with financial markets than with the real world. 
The reason for it readily suggests itself: financial markets them-

selves function imperfectly as a mechanism for predicting events 
in the real world. There is always a divergence between prevailing 
expectations and the actual course of events. Financial success 
depends on the ability to anticipate prevailing expectations and 
not real-world developments. But, as we have seen, my approach 
rarely produces firm predictions even about the future course of 
+ financial markets; it is only a framework for understanding the

course of events as they unfold. If it has any validity it is because 
the theoretical framework corresponds to the way that financial 
markets operate. That means that the markets themselves can be 
viewed as formulating hypotheses about the future and then sub- 
mitting them to the test of the actual course of events. The hy- 
potheses that survive the test are reinforced; those that fail are 
discarded. The main difference between me and the markets is

that markets seem to engage in a process of trial and error without 
the participants fully understanding what is going on, while I do 
it consciously. Presumably that is why I can do better than the 
market. 
If this view is correct, financial markets 'bear a curious resem- 
blance to scientific method: both involve the testing of hy- 
potheses. But there is a fundamental difference: in science, testing 
serves to establish the truth; in financial markets, the criierion is

operational success. In contradistinction with natural science, the 
two criteria do not coincide. How could they? Market prices al- 
ways express a prevailing bias, whereas natural science works 
with an objective criterion. Scientific theories are judged by the 
facts; financial decisions are judged by the distorted views of the 
participants. Instead of scientific method, financial markets em- 
body the method of alchemy. 
This interpretation of financial markets as a mechanism for test-

ing hypotheses by alchemy is both novel and challenging. The 
fact that it is not generally accepted adds to the challenge. How 
can markets be testing something when the participants don't 
know what they are doing? The answer is to be found in the

The Scope for Financial Alchemy 305 
results they achieve. Try to propound an unformulated hypothe- 
sis and you get a hit-or-miss result. By contrast, when you 
deliberately formulate your hypotheses, you can consistently out- 
perform the market ave~ages-provided your specific predictions 
are not too far off the qark. Treating the market as a mechanism 
for testing hypotheses seems to be an effective hypothesis. It pro- 
duces results that are better than a random walk.

This conclusion validates the approach I have taken over a 
strictly scientific one. If we abide by the methods of natural sci- 
ence, we arrive at the random walk theory. The hypotheses that 
are being tested have to'be disregarded because they do not con- 
stitute facts and what we are left with is a jumble of haphazard 
price fluctuations. On the other hand, if we look at the situation 
from the inside, from the vantage point of a participant, we dis-

cover a process of trial and error. It is not easy to make sense of 
the process: many people participate with only a vague idea of 
what is going on, and I must confess that the sensation of being 
on a random walk is not unfamiliar to me. My attempts at formu- 
lating conjectures about the future work only intermittently; 
oftentimes all I get is white noise. But when I succeed in formu- 
lating a worthwhile conjecture the results can be very rewarding,

as Phase 1 of the experiment demonstrates; and even if my per- 
ceptions are flawed, as was often the case in Phase 2, I have a 
criterion that I can use to identify my mistakes: the behavior of 
the market. d 
The real-time experiment has shown how greatly my decision- 
making process is influenced by the market action. At first sight 
this seems to contradict my original contention that markets are 
always wrong. But the contradiction is more apparent than real.

Markets provide the criterion by which investment decisions are 
judged. Moreover, they play a causal role in shaping the course of 
events. The information is more readily available than events in 
the real world; hence the market action offers the most convenient 
feedback mechanism by which one's expectations can be evalu- 
ated. One need not regard the market as always right in order to 
use it in that capacity. Indeed, if one believes that the market is

always right there is little to be gained from having a feedback 
mechanism because the prospect of outperforming the market be- 
comes a matter of pure chance, 
As I shall argue in Chapter 17, the contention of classical eco- 
nomic theory that the market mechanism assures the optimum

306 Evaluation 
t allocation of resources is false; its true merit is that it provides a 
criterion by which the participants can recognize their own mis- 
conceptions. But it is important to realize what kind of criterion 
the market provides: far from being always right, it always incor- 
porates the prevailing bias. If participants labor under the misap- 
prehension that the market is always right, the feedback they get 
is misleading. Indeed, the belief in efficient markets renders mar-

kets more unstable by short-circuiting the corrective process that 
would occur if particpants recognized that markets are always 
biased. The more the theory of efficient markets is believed, the 
less efficient the markets become. 
How good are financial markets in predicting real-world devel- 
opments? Reading the record, it is striking how many calamities 
t that I anticipated did not in fact materialize. The financial mar- 
kets must have come to reflect the same concerns; otherwise my

false expectations could not have proven so rewarding. This 
raises an interesting possibility. Perhaps some of the develop- 
ments I predicted were preempted by the very fact that they were 
anticipated by the market and the market provoked a reaction that 
prevented them from happening. This seems to hold true of the 
collapse of the banking system and of the collapse of the dollar, 
and also of the "bull market of our lifetime," which was to be

followed by a crash 1929 style. The monetary authorities became 
so concerned about the excessive buoyancy of financial markets 
that in the end they refused to supply the excess liquidity that 
would create a speculative bubble. Their action was neither delib- 
erate nor unanimous. In the U.S., Volcker was opposed to provid- 
ing excess liquidity but he was defeated in the Open Market 
Committee and had to appeal to Germany to join in a round of

interest rate reductions. When Secretary Baker pushed for another 
round, the Germans balked and the resulting row almost wrecked 
the Group of Five process. The Japanese devised their own medi- 
cine but by the time it took effect the speculative bubble was 
sufficiently developed to precipitate a more or less full-scale bust 
in the Japanese stock market. No wonder that I had difficulty in 
recognizing the premature demise of the bull market of a life-

time! * It is possible that the United States will continue to create 
excess liquidity, but I consider it unlikely that it will cause a 
speculative bubble because confidence has been too badly shaken. 
* Written before the revival of the bull market in January 1987

The Scope for Financial Alchemy 307 
It is more likely that investors would flee to liquidity and gold. 
When I finally recognized that markets can preempt the catastro- 
phes they predict, I concluded that we live in an age of self- 
defeating prophecies. 
The collapse of oil pdces does not seem to fit the argument 
because it actually occuirred; but that may be attributed to the 
fact that either I or the authorities have misjudged its dire con-

sequences. I expected shch severe repercussions on the bank- 
ing system and on the economy as to make a levy on imported 
oil indispensable, while we seem to have gotten along fine with- 
out it. In the end, it was left to OPEC to pull itself together. 
The present arrangement is 30 more permanent than the Group 
of Five process; the drama has yet to be played out in both 
cases. 
This line of argument opens up a fascinating vista. I may have

discovered not just a reasonably effective way of operating in 
financial markets but an actual model of how the financial mar- 
kets operate in the real world. Models currently in use are based 
on the misconception that markets can only foreshadow events, 
they cannot shape them. My approach recognizes that financial 
markets can also precipitate or abort future events. Following this 
line of argument, it is possible that we have indeed been teetering

on the verge of both a deflationary spiral and a free fall of the 
dollar-not to mention all sorts of other financial calamities- 
and we have been saved from them only because &the danger 
signals emitted by the financial markets. In other words, financial 
markets constantly anticipate events, both on the positive and on 
the negative side, which fail to materialize exactly because they 
have been anticipated. No wonder that fi~anciall markets get so

excited in anticipating events that seem quite harmless in retro- 
spect! It is an old joke that the stock market has predicted seven 
of the last two recessions. We can now understand why that 
should be so. By the same token, financial crashes tend to occur 
only when they are unexpected. 
This last point should not be overstated. There are many events 
that actually occur in spite of the fact that they were widely antic- 
ipated. The collapse in oil prices is a case in point; the outbreak

of the Second World War was another. It has become fashionable 
to be a contrarian, but to bet against prevailing expectations is far 
from safe. It will be recalled that, in the boom/bust model, events 
tend to reinforce prevailing expectations most of the time and

308 Evaluation 
contradict them only at the inflection points; and inflection points 
I are notoriously difficult to identify. Now that the contrarian view- 
point has become the prevailing bias, I have become a confirmed 
anti-contrarian.

THE QUANDARY OF THE 
SOGIAL SCIENCES 
We are now in a position to appreciate the predicament of the 
social sciences. Scientific method is based on the presumption 
that a successful experiment corroborates the validity of the hy- 
pothesis that is was designed to test. But in situations with think- 
ing participants, experimental success does not assure the truth 
or validity of the statements that are being tested. The real-time

experiment is a case in point: inconclusive and occasionally pa- 
tently false predictions were crowned by financial success. Ad- 
mittedly, the experiment was not a scientific one; I went to great 
lengths to emphasize its alchemical character. ButAhe very fact 
that alchemy can succeed raises questions about scientific 
method; and the fact that scientific theories do not seem to be able 
to produce superior results compounds the predicament. I shall

argue that social science is a hlse metaphor and we shall be better 
off if we recognize it as such. 
Scientific method works whenever scientists have an objective 
criterion at their disposal by which the truth or validity of their 
statements can be evaluated. The scientists' understanding is 
never perfect; but the objective criterion allows misunderstand- 
ings to be corrected. Scientific method is an interpersonal process 
in which the contribution of each participant is subjected to the

critical appraisal of all others. Only when all the participants are 
guided by the same criterion is the critical process capable of 
producing results that qualify as knowledge. That is why the 
availability of an objective criterion is indispensable to the suc- 
cess of scientific method.

310 Evaluation 
The role of an objective criterion is filled by facts. Statements 
I that correspond to the facts are true; those that do not are false. 
Unfortunately, the facts are not always as dependable as this sim- 
ple statement makes them out to be. They can serve as an objec- 
tive criterion only when they are totally independent of the 
statements that relate to them. That is the case in natural science 
where one fact follows another irrespective of what anybody

thinks. But it is not the case in social science where events incor- 
porate the participants' bias. It should be emphasized that the 
interference comes not only from scientists but also from partici- 
pants. Indeed, if the participants' thinking did not play a causal 
role in shasir,g ths course of events no observer could influencs 
the course of events by making statements about it and the situa- 
I tion of the social scientist would be no different from that of the

natural scientist. It is the participants' thinking that creates the 
problems. 
The structure of events that have no thinking participants is 
simple: one fact follows another in an unending causal chain. The 
presence of thinking participants complicates the structure of 
events enormously: the participants' thinking affects the course 
of events and the course of events affects the participants' think- 
ing. To make matters worse, participants influence and affect each

other. If the participants' thinking bore some determinate rela- 
tionship to the facts there would be no problem: the scientific 
observer could ignore the participants' thinking and focus on the 
facts. But the relationship cannot be accurately determined for 
the simple reason that the participants' thinking does not relate 
to facts; it relates to events in which they participate, and these 
events become facts only after the participants' thinking has made

its impact on them. Thus the causal chain does not lead directly 
from fact to fact but from fact to perception and from perception 
to fact with all kinds of additional connections between partici- 
pants that are not reflected fully in the facts. 
How does this complex structure affect the ability of an ob- 
server to make valid statements about the course of events? His 
statements must also be more complex. In particular, they must

allow for a fundamental difference between past and future: past 
events are a matter of record, while the future is inherently unpre- 
dictable. Explanation becomes an easier task than prediction-as 
the real-time experiment illustrates. Generalizations do not apply 
to the future with as much force as to the past, and the beautiful

The Quandary of the Social Sciences 311 
symmetry that characterizes the deductive-nomological (D-N) 
model of science is destroyed. This goes against the grain of sci- 
entific generalizations, which are supposed to be timelessly valid. 
It is possible to establish universally valid generalizations- 
witness the ones I proposed about freely fluctuating exchange 
rates-but they cannot be used to predict the course of events. 
What is worse, the facts ldo not provide an adequate criterion by

which the validity of gelieralization can be judged because there 
is more to the subject matter than facts. The fact that a prediction 
turns out to be true does not necessarily validate the theory on 
which it is based and, conversely, a valid theory does not neces- 
sarily generate predictions that can be checked against the facts. 
Indeed, the sequence of social events cannot be properly under- 
stood if we confine our attention to facts. The participants' think-

ing is an integral part of the situation they participate in; to treat 
such a situation as if it were composed exclusively of facts dis- 
torts the subject matter. The D-N model of scientific method, 
which we reviewed briefly in Chapter 1, is based on a strict seg- 
regation of facts and statements. Thus we are forced to the conclu- 
sion that the D-N model is not applicable to the study of social 
events. 
It would be a mistake to equate the D-N model with scientific

method. Even the theory of science recognizes other models, no- 
tably statistical or probabilistic ones and laws relating to an ideal 
case as in economic theory. Moreover, the practic;~ of science 
differs significantly from its theory and a study of these differ- 
ences has given rise to further refinements in the theory of science 
since the D-N model was originally developed. Nevertheless, the 
D-N model embodies the ideal that scientific method strives for:

universally valid generalizations that can be used for prediction 
and explanation with equal force and are amenable to testing. 
Natural science has so many accomplishments to its credit that it 
can dispense with theoretical models and pursue its investiga- 
tions wherever they may lead; but social science, exactly because 
it has been less successful, is in greater need of the prestige that 
the D-N format can impart. To abandon the D-N model is to give

up what is most valuable, persuasive, and attractive in science. 
But that is only half the story. When the course of events is 
influenced by the participants' bias, future events are open to 
manipulation by observers in a way that is not possible in natural 
science. That is the point I was trying to make by speaking of

312 Evaluation 
alchemy. Since alchemy is unable to influence natural phenom- 
I ena, the social sciences face a problem that has no parallel in the 
natural sciences. The critical process that is the foundation of 
science works smoothly only when the participants share the 
same objective. The avowed purpose of science is the pursuit of 
truth; but when the subject matter is open to manipulation, par- 
ticipants may be more interested in changing the course of events

than in understanding it. The fact that they can enhance their 
influence by claiming scientific status for their views undermines 
the critical process even further. 
How can scientific method protect itself against subversion? 
The first step is to recognize the danger. That requires the repu- 
diation of the "doctrine of the unity of science." People partici- 
t pate in science with a variety of motivations. For present 
purposes we may distinguish between two main objectives: the

pursuit of truth and the pursuit of what we may call "operational 
success." In natural science, the two objectives coincide: true 
statements work better than false ones. Not so in the social sci- 
ences: false ideas may be effective because of their influence on 
people's behavior and, conversely, the fact that a theory or predic- 
tion works does not provide conclusive evidence of its validity. 
Marxism provides an outstanding example of the first kind of

divergence; and my own prediction of the "bull market of a life- 
time" of the second. 
The divergence between truth and operational or experimental 
success undermines scientific method in more ways than one. On 
the one hand, it renders scientific theories less effective; on the 
other, it allows nonscientific theories to achieve operational suc- 
cess. What is worse, an alchemical theory can profit from assum- 
ing a scientific guise.

ing a scientific guise. 
We cannot remove the first two limitations because they are 
inherent in the subject matter; but we can protect against the 
third. All we have to do is to recognize the limitations of scientific 
method when it comes to dealing with social situations. This is 
what I propose to do by declaring social science a false metaphor. 
That means that the methods of natural science do not apply to 
the study of social events. It emphatically does not mean that we

ought to abandon the pursuit of truth in the study of social events. 
To try to argue about motivations would be totally counterprod- 
uctive. Every contribution must be considered on its merit and 
not on the basis of its intentions, otherwise the critical process

The Quandary of the Social Sciences 313 
which is at the heart of the scientific method would turn to sham- 
bles. It is noteworthy that two schools of thought that insisted on 
judging contributions by their source rather than on their merit, 
namely, Marxism and psychoanalysis, were also the most suc- 
cessful in subverting scikntific method. 
The only way to protect against subversion is to establish a 
special convention for the study of social phenomena. Instead of

demanding that contribdtions be cast in the D-N mold in order to 
qualify as scientific, theories of the D-N type would be treated as 
a form of social alchemy. The convention would not automati- 
cally disqualify every theory, prediction, or explanation that 
claims scientific status but it would put the burden of proof on 
them to justify their claim. It would prevent the abuse of scientific 
method for alchemical purposes and allow theories, like mine,

that do not produce unconditional predictions to qualify as valid 
contributions. The convention is necessary because without it the 
arguments I am presenting here would have to be repeated in each 
and every case, and that would be impractical to say the least. Try 
to convince a Marxist that Marxism is not scientific! 
I happen to be passionately interested in the pursuit of truth, 
but I am also fully cognizant of the need to attain operational

success in order to get a hearing for my views. As I admitted 
earlier, that consideration was a major driving force behind the 
real-time experiment. My success in the stock market has had the 
liberating effect of allowing me to speak my mind> am in the 
fortunate position of not needing operational success as a scien- 
tist, having been able to attain it as a participant. 
But people in the academic professions are not so lucky: they

compete directly with natural scientists for status and funds. Nat- 
ural science has been able to produce universally valid generali- 
zations and unconditional predictions. In the absence of a 
convention to the contrary, social scientists are under great pres- 
sure to come up with similar results. That is why they produce so 
many scientific-looking formulas. Declaring social science a false 
metaphor would liberate them from having to imitate natural sci- 
ence.

ence. 
Apart from academia, there are many fields where participants 
can obtain operational success by claiming scientific status for 
their views. Financial forecasting is one; politics is another. The 
history of ideas is littered with examples. Marxism is the political 
creed that has used a scientific guise most deliberately, but lais-

314 Evaluation 
sez-faire policies also derive their intellectual force from a scien- 
I tific theory-namely, the theory of perfect competition-and 
Freud was just as determined to claim scientific status as Marx. 
I have no grounds for impugning the motivations of others. 
After all, I have just as overwhelming a desire to see my views 
accepted as everybody else, and I am marshaling whatever argu- 
ments I can to support my views. Moreover, in my previous incar-

nation as a securities analyst I often espoused views that I knew 
to be distorted for the sake of their operational effect, so that I am 
no holier than anyone else. 
The question is not one of motivation but of operational effect. 
A csnsideratisn c.f the stnciure of social evzntz she;v:s that all 
predictions are contingent on the participants' decisions. Yet the 
I pursuit of operational success often drives people to try to com-

pete with natural science by making more unconditional predic- 
tions. This has the operational effect of endangering the pursuit 
of truth in the study of social phenomena. As long as the doctrine 
of the unity of science prevails, there is a direct conflict between 
the pursuit of truth and the pursuit of operational success. It can 
be resolved only by renouncing the doctrine. 
I have managed to claim exemption from the rigorous require-

ments of the D-N model by renouncing the doctrine of the unity 
of science. I went even further: I asserted that the pursuit of truth 
prohibits unconditional predictions. Does that mean that the 
kinds of conjectures I produced are the best that can be hoped 
for? Certainly not. The real-time experiment is best regarded as 
an amateur effort that ought to be improved upon when the ap- 
propriate professional skills are developed.

FREE MARKETS VERSUS REGULATION 
It is almost redundant to criticize the concept of equilibrium any 
further. In the first chapter, I asserted that the concept is a hypo- 
thetical one whose relevance to the real world is open to question. 
In subsequent chapters I examined various financial markets as 
well as macro-economic developments and showed that they ex- 
hibit no tendency towards equilibrium. Indeed, it makes more 
sense to claim that markets tend towards excesses, which sooner

or later become unsustainable, so that they are eventually cor- 
rected. 
Equilibrium is supposed to ensure the optimum-allocation of 
resources. If markets do not tend towards equilibrium, the main 
agrument that has been used in favor of the market mechanism 
loses its validity: we have no grounds for believing that markets 
optimize anything. 
This may sound like a startling conclusion, but it falls far short 
of that. The concept of an optimum is just as alien to a world in

which participants function without the benefit of perfect knowl- 
edge as the concept of an equilibrium, and for the same reason: 
both concepts presuppose perfect knowledge. So it is not at all 
surprising if both of them are shown to have little relevance to 
There are other arguments that can be advanced in favor of the 
market mechanism. Indeed, an interesting line of argument seems 
to emerge from the discussion in Chapter 15. I interpreted finan-

cial markets as a process that is somewhat akin to scientific 
method-that is to say, a process of trial and error in which the

318 Prescription 
market price at the termination of the experiment serves as a 
I criterion by which the experiment can be judged. The criterion 
does not meet the requirements of scientific method, because the 
market price is not independent of the participants' decisions in 
the way in which the events studied by natural scientists are 
independent of the statements that scientists make about them. 
Nevertheless, it is a useful criterion because it is just as real and

just as amenable to scientific observation as any natural phenom- 
enon. Moreover, it is of vital interest to market participants. Thus 
the market mechanism has the merit of providing an objective 
criterion albeit a biased one. 
Haw great that merit is we czn appreciate only xhen we con- 
sider what happens in its absence. For that purpose, we must look 
I at centrally planned economies which, in revulsion against the 
deficiencies of market economies, have eschewed the use of the

pricing mechanism. Output has to be measured in physical quan- 
tities, and the distortions are far worse than the excesses of the 
market. 
Winston Churchill once said that democracy is the worst form 
of government except for all the others. The same can be said 
about the market mechanism: it is the worst system of allocating 
resources except for all the others. Indeed, there are significant 
similarities between the election mechanism and the market

mechanism. It would be difficult to argue that elections optimize 
the political leadership of a country: the skills needed to attract 
votes bear little relevance to the qualities a candidate is going to 
need once he is in office. Nevertheless, the very fact that he has to 
run for election imposes a discipline which helps prevent some 
of the more egregious excesses. 
The value of an objective criterion is perhaps best appreciated

subjectively. We all live in a fantasy world. Having an affinity for 
abstract ideas, I am perhaps more apt to be carried away into a 
world of my own creation than many other people. The markets 
have always helped to preserve my sense of reality. It may seem 
paradoxical that my sense of reality should be rooted in the mar- 
kets when markets often behave so strangely that they strike other 
onlookers as unreal; yet as a market participant, I am not merely

aware of being connected to reality: I actually feel it in my guts. I 
react to events in the marketplace as an animal reacts to events in 
the jungle. For instance, I used to be able to anticipate an impend- 
ing disaster because it manifested itself in the form of a backache.

Free Markets Versus Regulation 319 
1 was of course unable to tell what shape the disaster would take: 
by the time I could identify it, my backache would dissolve. There 
was a time when my involvement with the market was all- 
embracing-much to the detriment of my relationships with 
human beings. Now that I have managed to distance myself, my 
market sense has sufferbd. Events often reach me as white noise: 
I cannot make sense of8 them. For instance, during the real-time

experiment, market dejelopments had sharp contours; during the 
control period, the outlines became more blurred. 
It is interesting to observe how my market involvement relates 
to my ability to organize abstract ideas. One would think that 
being active in the market would interefere with writing, but the 
opposite seems to be the case: the discipline of having to make 
investment decisions prevents me from getting too far divorced

from reality. During the three years that 1 was writing the The 
Burden of Consciousness, I lost my ability to make money in the 
stock market and eventually I got lost in my own abstractions. 
Again, during the three years when I was trying to make sense of 
the international debt problem I saw my ability to operate in the 
market diminish, and, what is worse, I sensed that my analysis of 
the debt problem was becoming increasingly removed from real-

ity. By contrast, the real-time experiment brought both my invest- 
ment activities and mysability to express myself to a high pitch. 
I mention this because it may have more than subjective rele- 
vance. Had I been an academic, I could have persbted with my 
analysis of the debt problem, and if reality failed to conform to 
my expectations, I could have defended my analysis by blaming 
extraneous developments. Eventually, some of my expectations

were fulfilled, albeit with a delay of several years. As a market- 
oriented man, I found such a delay intolerable, and I felt obliged 
to search for, and to recognize, the flaws in my argument. As an 
academic, I could have claimed to be vindicated. The point I am 
trying to make is that the market is a harder taskmaster than aca- 
demic debate. 
Yet it is easy to exaggerate the merits of having an objective 
criterion at our disposal. We have become so fixated on objective

criteria that we are inclined to endow them with a value they do 
not intrinsically possess. Profit-the bottom line-efficiency- 
takes on the aspect of an end in itself, instead of being a means to 
an end. We tend to measure every activity by the amount of 
money it brings. Artists are valued according to the price their

320 Prescription 
products sell for. What is worse, we often want to make a profit 
I from activities that ought to be otherwise motivated. Politicians 
want to earn lecture fees and sell their memoirs; White House 
aides become lobbyists; generals in charge of procurement angle 
for lucrative jobs in industry, and so do lawyers working for reg- 
ulatory agencies. The profit motive has become so all-embracing 
that we find it hard to accept when someone is motivated by

considerations other than profit. An American executive finds it 
a nuisance when an Englishman is unwilling to relocate for the 
sake of a better job, a South African black who prefers to destroy 
civilization rather than put up with apartheid strikes us as posi- 
tively barbaric-not to .mention a phecsmenon like Islamic fun- 
damentalism which is totally beyond our ken. Values that 
1 motivate people cannot be readily translated into objective terms;

and exactly because individual values are so confusing, we have 
elevated profit and material wealth-which can be readily mea- 
sured in terms of money-into some kind of supreme value. 
Surely that is an exaggeration. The fact is that in a world of im- 
perfect understanding, there is some kind of exaggeration or bias 
involved in every value. In our civilization, the value of profit is 
exaggerated and so is the value of objectivity.

exaggerated and so is the value of objectivity. 
Let us take a closer look at the kind of criterion market prices 
provide. The distinction we have drawn between scientific 
method and alchemy will come in useful. I have argued that in 
the study of social phenomena we need to distinguish between 
two kinds of validity: one associated with truth, the other with 
effectiveness. In natural science, the distinction is missing: theo-

ries are effective only if they are true; that is why alchemy does 
not work. Following this line of thought, we can argue that the 
market price provides a criterion of effectiveness but not a crite- 
rion of truth. Future market prices will determine how the various 
participants fare, but they will not determine whether their un- 
derstanding is correct. Only if market prices tended towards an 
equilibrium would the two criteria merge: the market price would 
then be the "correct" price.

then be the "correct" price. 
We can see now how important the concept of equilibrium is. 
It serves as a bridge between natural and social science and 
eliminates the disturbing dichotomy between truth and effective- 
ness that characterizes the study of social phenomena. Unfortu- 
nately, the bridge does not stand up, because imperfect 
understanding renders the concept of equilibrium inappropriate.

Free Markets Versus Regulation 321 
Without an innate tendency towards equilibrium, the course of 
events cannot be deterknined by scientific method; but it can be 
shaped by the methods of alchemy. 
The attempt to transpose the methods and criteria of natural 
science to the social sphere is unsustainable. It gives rise to in- 
flated expectations thai cannot be fulfilled. These expectations go 
far beyond the immediate issue of scientific knowledge and color

our entire way of thinking. The belief that economic policy ought 
to aim at the optimum allocation of resources has dominated po- 
litical thought-and political action-since the middle of the 
nineteenth century. Those on the left wanted the State to take 
charge of the allocation; those on the right wanted to leave it to 
the market mechanism. Under the influence of Marxism, the pur- 
suit of the optimum led to the total abandonment of the market

mechanism in large parts of the world. Even in market-oriented 
economies, the State was given a large role in correcting the im- 
perfections of the market mechanism. Gradually, the harmful side 
effects of State intervention have become increasingly evident, 
and the prevailing bias has swung back in favor of free markets. 
We are quite willing to recognize the fallacy in Marxism, but 
we are much less inclined to admit that the theory of perfect

competition is imbued with a similar fallacy. Both are built on 
the assumption of perfect knowledge. In one case, the assumption 
produces market equilibrium; in the other, it finds expression in 
an unconditional prediction of the course of histop. It is worth 
pointing out that both theories originated in the nineteenth cen- 
tury, when the limitations of knowledge were not yet recognized 
and science reigned supreme. 
Once we recognize that the optimum is unattainable, we me in

a better position to evaluate the merits and shortcomings of the 
market mechanism. I do not want to get involved in the problems 
connected with the distribution of wealth-not because I do not 
consider them important, but only because my analysis has little 
to contribute to the subject; I want to focus on one particular 
weakness of the market mechanism: its innate instability. Its 
cause has been identified: it derives from the two-way connection

between thinking and reality that I have labeled reflexivity. It is 
not in operation in all markets at all times; but if and when it 
occurs, there is no limit to how far away both perceptions and 
events can move from anything that could be considered equilib- 
rium.

322 Prescription 
Instability is not necessarily harmful; indeed, if it were de- ' scribed as dynamic adjustment, it would sound positively benign. 
But carried to extremes, it can give rise to sudden reversals that 
may take on catastrophic proportions. That is particularly the 
case where credit is involved, because the liquidation of collateral 
can lead to sudden compression of market prices. The prevention 
of excessive instability is therefore a necessary condition for the

smooth functioning of the market mechanism. It is not a condition 
that the market mechanism can ensure on its own. On the con- 
trary, I have presented evidence that unregulated financial mar- 
kets tend to become progressively more unstable. The evidence is 
most clea-cut ir, the currancy markets, but it is also qiiite psrana- 
sive with regard to the expansion and contraction of credit. 
t Whether stock markets would prove inherently unstable if there

were no credit involved remains an open question, because stock- 
market booms are always associated with credit expansion. Ex- 
cessive instability can be prevented only by some sort of regula- 
tion. 
How much instability is excessive is a matter of judgment. Stan- 
dards vary with time. The degree of dislocation we are willing to 
tolerate today, as measured by unemployment figures, would 
have seemed inconceivable a few decades ago when the memories

of the Great Depression were still fresh and the drawbacks of full- 
employment policies less evident. Similarly, the restrictions on 
corporate restructuring have been greatly relaxed between the 
conglomerate boom of the 1960s and the mergermania of the 
1980s. 
The trouble with regulation is that the regulators are also 
human, and apt to err. In order to avoid arbitrary behavior and 
abuse of power, rules and regulations need to be fixed in advance,

and it is difficult to devise regulations that are flexible enough to 
meet all contingencies. Regulations tend to be rigid and to hinder 
innovation. The rigidities and distortions they introduce tend to 
be just as cumulative as the instability of an unregulated market. 
Income taxes provide a good example. The steeper the rates and 
the longer they stay in effect, the more widespread the tax avoid- 
ance and the more complex the tax code.

ance and the more complex the tax code. 
I do not want to keep the discussion at such a high level of 
generality much longer, because it can easily deteriorate into 
empty phrases. I shall try to make some policy suggestions in the 
next chapter; here I want to make only one general point. Both

Free Markets Versus Regulation 323 
regulation and unrestrained competition can be harmful when 
carried to extremes, but the failure of one extreme is no justifica- 
tion for turning to the other. The two extremes should be treated 
not as alternatives, but as limits, within which the right balance 
needs to be struck. Tbe task is complicated by our innate ten- 
dency to be biased in one direction or the other. 
In The Burden of ;Consciousness, written some twenty-five

years ago, I developed a rather elaborate scheme along these lines. 
I took the rate of change as my critical variable, and I argued that 
people, with their imperfect understanding, are bound to exagger- 
ate it in one directiori or the other. One extreme yields a tradi- 
tional or a dogmatic inode of thinking according to which the 
existing arrangements have to be accepted as they are because it 
is inconceivable that they should be otherwise. The other extreme

produces a critical mode of thinking in which everything is con- 
sidered possible until disproved. Each mode of thinking is linked 
with a form of social organization which corresponds to it with 
the degree of imperfection that is appropriate to the imperfect 
understanding of the participants. In this way, the traditional 
mode of thinking is associated with tribal society, the dogmatic 
mode with totalitarian society, and the critical mode with Open

Society. Needless to say, I was very much under the influence of 
Karl Popper. I opted for Open Society, but the choice was not 
without qualification. Each form of social organization was found 
wanting in something that could be found only% its opposite: 
totalitarian society lacked freedom; Open Society lacked stability. 
But given our innate bias, a stable equilibrium between the two is 
just as unlikely to be attained as a stable equilibrium in a free

market. Sentiment is likely to swing in one direction or the other. 
After nearly half a century of what now appears as excessive 
regulation, we have been moving towards excessive deregulation. 
The sooner we recognize that some kind of regulation is necessary 
in order to maintain stability, the better our chances of preserving 
the benefits of a nearly free market system.

TOWARD AN INTERNATIONAL 
CENTRtZL, BANK 
We have concluded that financial markets are inherently unsta- 
ble. What practical measures are needed to prevent them from 
breaking down? I find myself ill-qualified to provide an answer. 
My strength lies in identifying the flaws in any system and not in 
designing systems. I have long nurtured the fantasy of becoming 
an economic reformer a la Keynes but the closer I come to getting 
a hearing for my views, the more acutely aware I become of my

own limitations. My particular expertise is derived from the in- 
sight that all systems are flawed; but my understanding of any 
particular system is always inferior to that of the experts. This 
holds true for security analysis as well as finance and economics. 
When I sat for an examination as supervisory security analyst, I 
failed in every subject; in analyzing the credit-cum-regdatory 
cycle, I felt the lack of a thorough grounding in the theory of

money; and, as the reader saw, in the real-time experiment my 
greatest weakness was in economic forecasting. Both in my in- 
vestment activities and in writing this book I could take the state 
of the art in any particular subject as given without actually pos- 
sessing it; but when it comes to designing a new financial system, 
my lack of knowledge becomes a decided drawback. 
Nevertheless, I feel I have a contribution to make, especially as

the prevailing wisdom has so little to offer. Keynesianism (as 
distinct from Keynes) has been discredited by the inflation of the 
1970s; monetarism is in the process of being shown to be irrele- 
vant to a regime of variable exchange rates and large-scale inter- 
national capital movements; and supply-side economics turns out

Toward an International Central Bank 325 
to be not much more than a pun on the Keynesian emphasis of 
the demand side. There is a general malaise, but no clear ideas. In 
these circumstances even my vague and tentative ideas may prove 
useful. 
First, I think we sh~uld distinguish between economic policy 
and systemic reform. Both are necessary, but neither is sufficient 
by itself. It is difficult ;to imagine how any system could function

fully automatically. Experience shows that every system-be it 
the gold standard, Bretton Woods, or freely floating exchange 
rates-has broken down when it was not supported by the appro- 
priate economic polidies. It is equally difficult to see how eco- 
nomic policies could 'correct the prevailing inhalances without 
some sort of systemic reform. The various imbalances are inter- 
connected and it is impossible to deal with one without affecting 
the others.

the others. 
We are confronted with a disconcerting array of imbalances and 
instabilities. To mention but a few: unstable exchange rates, the 
international debt problem, the chronic budget and trade deficits 
of the United States, the chronic trade surplus of Japan, a chronic 
worldwide surplus of agricultural and mineral products, unstable 
commodity prices with particular emphasis on oil, unstable inter- 
national capital movements, and unstable international financial

markets. Some of these instabilities are caused by economic poli- 
cies and can be altered only by pursuing different ones; others are 
inherent in the prevailing system and can be cured%nly by chang- 
ing the system. 
We can take as an example of the first kind of imbalance the 
desire of the Japanese to produce more than they consume and 
the apparent desire of the United States to consume more than it 
produces. If unchecked, these tendencies will lead, in due course,

to the rise of Japan as the dominant economic power of the world 
and to the decline of the United States. The transition is bound to 
cause a great deal of commotion and dislocation, but its occur- 
rence can be prevented only by changing economic and financial 
policies and not by changing the financial system. The system 
itself must be able to accommodate the transition, insofar as it 
occurs; otherwise it will break down to the detriment of all parties 
concerned.

concerned. 
An example of the second kind of imbalance is the prevailing 
system of exchange rates. As we have seen, freely floating ex- 
change rates are cumulatively destabilizing. The fact has now

326 Prescription 
I been recognized by the authorities, and the Plaza agreement has 
committed them to managing the exchange rates. But there is no 
agreement on how to do it. Managing exchange rates is tanta- 
mount to coordinating economic policies. If coordination can be 
achieved on a voluntary basis, well and good. If not, a different 
system will have to be devised. 
In this chapter I shall explore the possibilities for systemic re-

form; the appropriate economic policies will be discussed only 
tangentially. 
In my opinion, there are three major problem areas that require 
systemic reform: exchange rates, commodity pricing with special 
emphasis on oil, and international debt. Each of these problem 
areas has a number of aspects that cannot be dealt with individ- 
I ually but only as part of the whole system. There is a fourth major 
problem area that is not even recognized as such: international

capital markets. They reflect, accommodate, and help to generate 
the various other imbalances. Their rapid development is univer- 
sally acclaimed as a welcome innovation and treated as yet an- 
other instance where markets spontaneously adjust to changing 
needs. I contend that, in retrospect, the rapid growth of interna- 
tional capital markets will be recognized as yet another excess, 
similar to the rapid growth of international bank lending in the

1970s. We all know that the international lending boom was 
based on faulty foundations; I believe it is only a matter of time 
before the flaws in international capital markets will be recog- 
nized. 
At present, there is a strong predilection for treating problems 
on a case-by-case basis. It is now generally agreed, for instance, 
that exchange rates cannot be allowed to drift any further without 
interference; but it is also agreed that the.interference has to be

gradual and tentative. The debate revolves around the question of 
target zones: should they be tacit or explicit? The possibility of 
returning to fixed exchange rates is more or less ruled out. Simi- 
larly, there is a recognition that the international debt problem 
requires some new initiative; but the Baker Plan emphatically 
insists on a case-by-case approach. It is easy to see why. A conces- 
sion granted to one country can easily spread to all others, so that

any talk of systemic reform can precipitate a breakdown of the 
system. As far as oil prices are concerned, the matter is left to 
OPEC; the idea that consumer countries ought to cooperate to 
bring stability to the industry has not even been broached.

Toward an International Central Bank 327 
The step-by-step approach advocated by James Baker represents 
a significant advance oier the hands-off approach taken by Don- 
ald Regan when he was at the Treasury. It constitutes a recogni- 
tion that markets cannot be left to their own devices, that the 
authorities have to proyide some direction if a breakdown is to 
be avoided. The initiatibe taken at the Plaza meeting of the Group 
of Five touched off a major rise in the world's stock and bond

markets. But the momentum generated by the Plaza meeting has 
dissipated and we are once again drifting dangerously, If the 
momentum could be recaptured by ad hoc measures, well and 
good. But without effective international cooperation the dangers 
of protectionism, currency dislocations, and a breakdown in debt 
service loom larger than ever, and the need for systemic reform 
becomes correspondingly more pressing. 
Once we turn to systemic reform, the approach has to be com-

pletely reversed. Instead of dealing with individual problems in 
isolation, we must tackle them all at the same time. Problems that 
appear intractable on their own may fall into place within a larger 
solution. The more cdmprehensive the scheme, the better its 
chance of success. Perhaps the three or four major problem areas 
I have mentioned could be treated separately, but it would be 
more effective to deal with them simultaneously. 1 realize that

any radical change in prevailing arrangements goes against the 
grain, especially in matters of international cooperation where the 
common good has to be whittled down to accommdate national 
interests. But there are times when reforms are both possible and 
necessary. Usually, those are times of crisis. 
In the following pages I shall discuss the major problem areas 
separately, but the solution I shall suggest will link them together.

It involves the creation of an international central bank. Histori- 
cally, central banking has evolved in response to crises. Each 
central bank has its own history, although developments in one 
financial center have also affected the others. The problems of the 
present time are primarily international; hence, the solution must 
also be international. We have the beginnings of international 
central banking institutions: the Bank for International Settlement

was organized in 1930 in response to the German debt problem; 
the IMF and the World Bank were founded in 1944 at Bretton 
Woods. The next step ought to involve an enlargement of their 
functions or the establishment of a new institution.

328 Prescription 
t Exchange Rates 
Exchange rate misalignments have become a major source of dis- 
ruption for the world economy. They make it unsafe to make long- 
term investments, they endanger the value of investments already 
made, and they are at the root of protectionist sentiment in the 
United States. The market mechanism fails to bring currencies 
back into alignment. On the contrary, speculation tends to exag- 
gerate currency moves. As we have seen, the system of freely

floating currencies is cumulatively destabilizing. 
The question is: what can be done about it? A number of ar- 
rangements are possible. Target zones, either tacit or explicit, con- 
I stitute the least radical and therefore the most often mentioned 
alternative. We could also return to a system of fixed exchange 
rates, with or without relying on gold as the standard of value. 
Or, most daring of all, we could establish an international cur- 
rency.

rency. 
Whichever arrangement is chosen, a number of problems need 
to be resolved. First and foremost is the problem of international 
capital movements. The transfer of capital across national fron- 
tiers is highly desirable and ought to be encouraged; but specula- 
tive capital movements, as we have seen, are cumulatively 
destabilizing. We need a system that renders speculation unprof- 
itable. Ideally, currency fluctuations ought to be kept within the

confines of interest rate differentials; but that would entail a sys- 
tem of more or less fixed exchange rates. 
Target zones are unlikely to discourage speculation. On the 
contrary, they may constitute an invitation to speculate against 
the authorities with limited risk. By endorsing a set of target 
zones, the authorities would expose themselves to speculative 
attack at a time and place chosen by the speculators. History 
shows that under these conditions the speculators usually win. It

could be argued that an explicit target zone system constitutes the 
worst of all possible worlds because it would reward speculation 
within the system as well as encouragino speculative attacks 
against the system. 
Unannounced target zones have a somewhat better chance of 
success. They would pit the authorities against speculators in an 
intricate cat and mouse game that the authorities have a chance 
of winning, provided they act in unison and mobilize larger re-

Toward an International Central Bank 329 
sources than speculatqrs. Since they control the ultimate weapon 
-the printing press-their task is not impossible. A strong cur- 
rency can always be prevented from appreciating futher provided 
the central bank is willing to supply it in unlimited quantities. 
The curious fact is tha! central banks have rarely had the nerve to 
do so. 
If the authorities sljcceeded in stablizing exchange rates, hot

money would eventually cool off and find its way into long-term 
investment-an essential prerequisite for a sounder world econ- 
omy. But stabilizing the relative values of the major currencies is 
not enough: the value of all the currencies taken together must 
also be kept stable if ~e are to avoid inflationary and deflationary 
excesses on a worldwide scale. Gold has served as a stabilizer 
throughout history and it may play that role again in one form or

another, although it has one great drawback at the present time: 
the bulk of fresh supplies is produced by two prison administra- 
tions-namely, South Africa and the Soviet Union. In any case, 
the problem is not only one of finding a suitable monetary base; 
given the reflexivity of credit, the credit structure that is erected 
on that base also needs to be regulated. What is needed is an 
institution that coordinates the growth of credit on a worldwide 
scale: an international central bank.

scale: an international central bank. 
At this point in the argument, the other major problem areas, 
namely, international debt and commodity prices with special 
reference to oil, also need to be considered. rYir 
International Debt 
The burden of accumulated debt continues to weigh heavily on 
lenders and borrowers alike. It was hoped that they could grow 
their way out of the problem, but calculations failed to take into 
account the erosion of collateral values that occurs when debts

are liquidated. In the case of balance-of-payments loans, the col- 
lateral consists of exports. Less developed countries export 
mainly commodities that face inelastic demand: as they try to 
increase their exports, commodity prices come under pressure. 
Some of the major debtor countries managed to enter what I 
have called Phase 3 of the adjustment process but others seem 
permanently mired in a deficit position. Raising the production

330 Prescription 
avenues of growth need to be pursued. Exporting more sophisti- 
I cated products is one possibility, but it is running into the road 
block of protectionism. That leaves domestic growth in less de- 
veloped countries as the main route to recovery. Politically, it is 
highly desirable, because the United States may be more willing 
to absorb imports if exports showed some signs of picking up; 
moreover, public opinion in debtor countries is increasingly in-

sistent on domestic growth. 
The Baker Plan was designed to bring relief to heavily indebted 
countries by increasing the flow of new lending. The funds would 
come partly from international institutions, notably the World 
Bank and the inter-American Development Bank, and partly from 
commercial banks. Commercial banks were asked to pledge $20 
I billion over three years. The loans would have cross-default 
claims, which would make them more secure than purely com-

mercial loans. When the resources of the World Bank are ex- 
hausted, the administration would go to Congress to ask for a 
capital increase. 
The plan is a step in the right direction, but it leaves two prob- 
lems unresolved: one is the accumulation of additional debt by 
the borrowing countries at a time when they cannot meet their 
already existing obligations; the other is the accumulation of 
doubtful loans on the books of the commercial banks at a time

when they already have too many such loans. The plan would 
mitigate the second problem because a large portion of new loans 
would come from government institutions, but it would not elim- 
inate it altogether. On the other hand, it lays itself open to the 
accusation that it constitutes a bailout for the banks. This will 
make it difficult to get Congress to approve an increase in the 
World Bank's capital. 
It is clear that the plan does not go far enough. It fails to deal

with the legacy of past excesses. In the absence of government 
intervention the accumulated debt would have been liquidated in 
catastrophic fashion. If a policy of intervention is to succeed, it 
must reduce the accumulated debt in an orderly manner. 
The experience of the last few years shows that, once the weight 
of accumulated debt passes a certain critical point, it cannot be 
reduced by a normal process of adjustment. In most Latin Ameri-

can countries, adjustment has been pushed to the limits of endur- 
ance and negative resource transfers have reached and already 
passed their maximum. Nevertheless, external debt has continued

Toward an International Central Bank 331 
to accumulate and debt ratios have showed little, if any, improve- 
ment. Moreover, internal debt has been rising at an alarming rate. 
In every advanced economy, special legal procedures have been 
established to deal with excessive indebtedness. Bankruptcy law 
serves to assure the orgerly liquidation of bad debt without undue 
economic disruption. We are badly in need of some kind of bank- 
ruptcy procedure for ipternational debt.

ruptcy procedure for ipternational debt. 
The principles of a bankruptcy reorganization are simple. The 
clock is stopped at a certain point in time. All existing assets and 
obligations are thrown into a pot, to be sorted out in lengthy 
litigation. In the meantime, the entity is allowed to function, if it 
is viable, free of the burdens of the past. The obligations of the 
ongoing entity take precedence over the obligations of its prede-

cessor. It is this principle that allows the bankrupt entity to con- 
tinue functioning. , 
International lending knows no equivalent procedure for set- 
tling bad debt. There have been many precedents where debts 
have not been paid in,full. Usually, nonpayment has resulted in 
total default and the situation was normalized only several de- 
cades later, when the lenders were happy to settle for a few cents 
on the dollar. The most comprehensive attempts at debt reorgan-

ization without total default were the Dawes and Young plans for 
Germany in 1924 and 1929, respectively, and they did not have a 
happy outcome. 
The example of domestic bankruptcy procedure$Ts not directly 
applicable to the present situation because the amounts involved 
are so large that, if payments were suspended even temporarily, 
the lenders would also go bust; but the principle of drawing a line 
under the past is the correct one.

under the past is the correct one. 
At present, all market participants are aware of an unresolved 
problem. Foreign lenders seek to keep their commitments to the 
minimum and domestic capital seeks shelter abroad. The econo- 
mies of the heavily indebted countries continue to languish and 
political pressures intensify. These trends need to be reversed. 
We are dealing with a reflexive process. A reversal of trend re- 
quires a climactic event whose impact is sufficient to alter the

prevailing bias. Only a comprehensive scheme of reorganization 
would constitute such an event. 
I am not in a position to put forward a concrete plan of action. 
Such a plan would require a great deal of preparation and negoti- 
ation. All I can do here is to provide a rough sketch of what it

332 Prescription 
I may look like. It will have to deal with at least five major topics: 
(1) the treatment of preexisting debt; (2) the provision of new 
credit; (3) the preservation of the banking system; (4) economic 
policies in the debtor countries; and (5) the repatriation of flight 
capital and the attraction of foreign investment. Senator Bradley 
proposed a plan in June 1986 that touches on all of these p0ints.l 
Henry Kaufman outlined a plan very similar to my own on De-

cember 4, 1986.2 These contributions are moving the discussion 
in the right direction. 
The preexisting debt could be consolidated into long-term ne- 
gotiable bonds with concessionary interest rates. The bonds 
would sell at a fraction of their par value and the banks holding 
the bonds would suffer substantial losses. To protect them, banks 
I would be allowed to write down their bonds to the market value 
gradually over a period of years. During that time the bonds could

be used at their gradually depreciating official value as collateral 
for borrowing at the discount window of the central bank. This 
would prevent a run on those banks whose financial positions 
had been impaired by the reorganization: they would be allowed 
to earn their way out of a hole. 
To reorganize preexisting debt is not enough; a continuing flow 
of new credit must be secured to enable the heavily indebted 
countries to recover. Commercial banks cannot be counted on.

They should not have provided credit for balance-of-payments 
purposes in the first place; they have learned their lesson and 
would be unwilling to lend even if they did not suffer any losses 
on their existing commitments. Balance-of-payments lending 
ought to be the province of an international lending institution 
that has the clout to insist that borrowing countries follow appro- 
priate economic policies. 
At present, the major internal problem in the heavily indebted

countries is inflation. As long as the servicing of foreign debt 
generates a large budget deficit there is little hope of curbing it. 
But once the debt burden is reduced, domestic reforms would 
have a better chance of succeeding. With less inflation real inter- 
est rates would rise, flight capital would be encouraged to return, 
and perhaps even foreign capital could be attracted once again. 
To provide an adequate flow of new credit, the World Bank (or

a new institution designed for the purpose) would need a large 
amount of capital. At present, the political will to make the nec- 
essary capital available is missing: any enlargement of interna-

Toward an International Central Bank 333 
tional financial institutions would be perceived as a bailout for 
the banks or for the debtor countries or for both. A comprehensive 
scheme that would require both creditors and debtors to contrib- 
ute to the limits of their abilities ought to be able to overcome 
these objections. The new loans would not go to service existing 
debt; they would serve to stimulate the world economy at a time

when the liquidation of bad debts is having a depressing effect 
and stimulation is badiy needed. 
Oil 
There is a painless way in which the capital needed by the World 
Bank could be obtained. It involves a grand design that combines 
an oil stabilization scheme with a solution to the international 
debt problem. I first thought of it in 1982. I outlined it in an article 
that was rejected with scathing comments and never published. It

was considered too far-fetched then and it will probably be con- 
sidered the same today. The interesting point about the article is 
that the problem that prompted its writing has not gone away. 
The article is just as timely now as it was when it was written. 
The reader can judge for himself because I shall reproduce it more 
or less verbatim. 
4- 
AN INTERNATIONAL BUFFER STOCK SCHEME FOR OIL * 
This article will outline what could be achieved by interna-

tional cooperation if the willingness to cooperate were present. 
There are many possibilities: I shall focus on the optimum that 
could be achieved. The point in doing so is to show that a work- 
able solution is conceivable. This may help generate the will to 
put it into effect. 
The optimum solution would require an agreement between the 
major oil-importing and oil-exporting countries. It would replace 
OPEC with an organization that would combine the essential fea-

tures of a cartel-price fixing and production quotas-with those 
of an international buffer stock scheme. 
It is not necessary or even desirable that all the consuming and 
producing countries should participate. Cooperation of the indus- 
trialized countries and the "moderate" members of OPEC is indis- 
* Written in 1982.

334 Prescription 
pensable, but the scheme could work without including 
t producers like Iran, Libya, or Algeria. 
The scheme would work as follows. Production and consump- 
tion quotas would be established. The aggregate amount of the 
quotas would be in excess of the present level of consumption. 
The excess would go into a buffer stock. Since it is expensive to 
store oil, the buffer stock would exist mainly on paper: the oil 
would be kept in the ground.

would be kept in the ground. 
Payment would be made not directly to the producing country 
but into a blocked account at a special facility of the IMF. The 
funds would be held in favor of the producing countries whose 
production quotas were not filled by actual sales. The oil would 
be paid for by those consuming countries that did not fill their 
consumption quotas with actual purchases. It would be held on 
the books of the buffer stock authority at the disposal of the coun-

try that paid for it. The buffer stock authority, in turn, would hold 
the oil in the ground of the producing country until needed. Ob- 
viously, the buffer stock authority would have to be satisfied that 
the oil in the ground is secure. 
The consuming countries would impose a levy on imported oil. 
They would rebate a portion of the oil levy to those producing 
countries that participate in the scheme. Nonparticipating pro- 
ducers would not be entitled to a rebate to penalize them for not

participating. The rebates would also be deposited into the 
blocked accounts at the special facility of the IMF. The blocked 
accounts would bear interest at a very low rate, say 1%. 
Producers with large outstanding debts, such as Mexico, Vene- 
zuela, Nigeria, and Indonesia, could use their blocked accounts 
to repay their debt; countries with surpluses, such as Saudi Ara- 
bia and Kuwait, would build up credit balances. 
Less developed countries would be exernpted from having to

participate in the buffer stock scheme. They would then have the 
advantage of being able to buy oil at a cheaper price than the 
industrialized countries. Their absence would not endanger the 
scheme. 
For purposes of illustration, let us assume that the benchmark 
price were kept at $34; the levy would be quite large, say, $17, 
half of which, $8.50, would be rebated to producers. Quotas 
would be fixed quite high so that the buffer stock started accu-

mulating at a daily rate of say 3 million barrels. If the industrial- 
ized countries were importing oil at a rate of only 15 million 
barrels a day, and 80% of the oil came from participating produc- 
ers, they would realize $55.8 billion a year from the levy and pay 
out $28 billion for buffer stock purchases. The rest would contrib-

Toward an International Central Bank 
ute to a reduction of budget deficits putting the industrialized 
countries in a favorable position to provide the necessary equity 
capital to an enlarged World Bank. The IMF special facility would 
receive $65 billion a year, all for the credit of producing countries: 
$37.2 billion from the producers' share of the oil levy and $28 
billion from the buffbr stock. By comparison, the net increase of

international lending was about $60 billion at its peak in 1980 
and 1981. I 
What would happen to the market price of oil? Since the 
blocked account pays only 1% interest, there is an inducement to 
make physical sales rather than sales to the buffer stock. The price 
paid by the buffer stock would therefore serve as a ceiling: the 
free market price would settle somewhere below the benchmark 
price, less the unrebated portion of the levy, that is, $25.50. For

consumers and producers in the industrialized countries, the 
price would of course include the levy. Should the price rise 
above the benchmark it would be an indication that demand is 
strong and it would be time to raise production quotas. 
How to adjust quotas and prices presents a gamut of tough 
problems. Most atterhpts at market regulation flounder because a 
suitable adjustment mechanism is lacking. This is true even of 
the international monetary system: the Bretton Woods arrange-

ment broke down because of the inflexibility of the price of gold. 
The more the scheme relies on price as the adjustment mecha- 
nism, the better its chances of survival. Recognizing this princi- 
ple, the buffer stock should be used only to give the price 
mechanism time to do its work. That means that afterthe initial 
buildup of a buffer stock, whenever it is beginning to be drawn 
upon there would be an upward adjustment, first in production

quotas and then in prices. When the buffer stock is beginning to 
build up again, there would be a reduction in production quotas 
down to the minimum established at the outset. 
The allocation of production quotas is one of the thorniest prob- 
lems. Initial quotas would be based on the irreducible financial 
needs of the countries involved; as the global amount of produc- 
tion is increased the allocation of the increased amounts would

have to be guided more by considerations of unused production 
capacity, size of reserves, and rate of increase or decrease of re- 
serves. The Saudi quota, for instance, would have to rise more 
than the Algerian or Venezuelan. Even if some formula could be 
developed, there would be a large element of discretionary judg- 
ment involved. 
Eventually, as production capacity is more fully utilized, the 
unwillingness of individual producers to increase their quota

Prescription 
could serve as the trigger mechanism for increasing prices. Again 
there would be an element of judgment involved. 
The allocation of consumption quotas would be quite simple 
by comparison: estimates using actual consumption figures could 
serve as the basis. 
To exercise discretionary powers, authority is required. How 
such an authority would be constituted and the voting rights di- 
vided presents the most difficult question of all. It can be settled

only by hard bargaining; the outcome would reflect the bargaining 
power and bargaining skills of the parties involved. 
Undoubtedly, there would be a major shift of power from the 
oil-producing to the industrialized countries. That is only appro- 
priate when OPEC is being saved from collapse. It is my conten- 
tion that the collapse of OPEC would have such calamitous 
consequences that it would have to be prevented one way or 
another. One of the major arguments in favor of embarking on the

comprehensive scheme outlined here is that the industrialized 
countries might as well gain the maximum benefit from a devel- 
opment that they would have to acquiesce in anyhow. How much 
they can gain depends on the skill, courage, and cohesion they 
demonstrate. The scheme outlined here would be much more 
advantageous than patching up OPEC. 
The ultimate merit of the scheme would depend on how the 
funds accumulating at the IMF special facility would be used.

The amounts involved are very large: larger than the accumula- 
tion of international debt at its peak; they would remain very large 
even when the buffer stock stopped growing. The funds should 
be sufficient to finance a global reorganization plan for sovereign 
debt. 
The blocked funds held by the IMF would be lent to the World 
Bank to provide credit to hecsrily indebted countries; they could 
also be used to buy up their outstanding debt at a discount. The

cash income earned on these loans could, in turn, be used to 
unblock the blocked accounts at the IMF. 
How would the various parties to the scheme fare? That would 
depend largely on the terms arrived at by negotiations. Neverthe- 
less, the broad outlines are clear. 
The industrialized countries would give up the benefits of a 
lower oil price in the near term in exchange for long-range price 
stability, the accumulation of a buffer stock, a solution for the

international debt problem, and a significant contribution to gov- 
ernment revenues. They would also have the benefit of protecting 
their domestic energy and oil sewice industries, if any. 
Producing countries that participated would be assured of a

Toward an International Central Bank 337 
market for their oil production at a volume substantially higher 
than at present. The price they receive would be less than at 
present, but higher than it would be if OPEC collapsed. They 
would have two powerful inducements to participate: the rebate 
on the oil levy and the ability to sell to the buffer stock. It is true 
that both would be palid into blocked accounts at the IMF, but oil- 
producing countries *with debts would have access to the ac-

counts for debt repayinent purposes; those with surpluses would 
have their funds unblocked only after a long delay. 
The less developed non-oil-producing countries would obtain 
substantial relief from being able to buy oil at a cheaper price 
than industrialized countries. Both producing and consuming 
countries would behefit from the global debt reorganization 
scheme. 
This article does not deal with the problem of how such a 
comprehensive scheme could be brought into existence-how

one could get from here to there. Probably it would require a 
worse crisis than is currently visible to bring the various parties 
together. 
The plan outlined above would have to be revised in the light 
of changed circumstances. Both the benchmark price and the size 
of the levy would have to be substantially lower than the figures 
used above, reflecting the erosion in OPEC's monopoly profits 
that has occurred since the scheme was formulated.

I am reluctant to invest any effort in revising the Pfan because I 
recognize that it is totally unrealistic, given the prevailing bias. 
Any kind of buffer scheme would be instantly laughed out of 
court, and the dismissal would be justified by the past history of 
buffer stock schemes. But the argument can be turned around. Is 
the experience with the market mechanism any better? Look at 
the history of oil. The only periods of stability were those when

there were excess supplies and a cartel-type arrangement was in 
operation. There were three such episodes: first, the monopoly 
established by Standard Oil; second, the production quota system 
operated by the Texas Railroad Commission; and third, OPEC. 
Each episode was preceded and followed by turmoil. If some sort 
of stabilization scheme is necessary, should the task be left to the 
producers? Ought not the consuming countries, whose vital inter-

ests are affected, take a hand in the arrangements? When the force 
of this argument is recognized, it will be time to take the plan out 
of the drawer.

338 Prescription 
I An International Currency 
Once the idea of a buffer stock scheme for oil is accepted, it is a 
relatively short step to the creation of a stable international cur- 
rency. The unit of account would be based on oil. The price of oil 
would be kept stable by the buffer stock scheme although its 
value, in terms of other goods and services, may gradually appre- 
ciate if and when demand outstrips supply. In other words, na-

tional currencies would gradually depreciate in terms of the 
international currency. 
The newly created international lending agency would use oil 
as its unit of account. Since its loans would be protected against 
h inflation, they could carry a low rate of interest, say, 3%. The 
difference between interest earned (3%) and interest paid on 
blocked accounts could be used to unblock the accounts. As 
the blocked accounts diminish, the lending agency builds up its 
own capital.

own capital. 
The lending agency could be endowed with the powers that 
usually appertain to a central bank. It could regulate the world- 
wide money supply by issuing its own short-term and long-term 
obligations, and it could play a powerful role in regulating the 
volume of national currencies in terms of its own unit of account. 
It could exercise the various supervisory functions that are per- 
formed by central banks. Its unit of account would constitute an 
international currency.

Commercial loans could also be designated in the international 
currency. Eventually, the oil-based currency could replace the 
dollar and other national currencies in all types of international 
financial transactions. The transition would have to be carefully 
orchestrated and the institutional framework developed. This is 
not the place, and I am not the man, to design a comprehensive 
scheme. It is clear that an oil-based currency could eliminate

speculative influences from international capital transfers. 
Whether the establishment of such a currency would be accept- 
able to all parties concerned is the crucial question. The United 
States, in particular, has much to lose if the dollar ceased to be 
the main international currency. For one thing, the home country 
of the reserve currency is in an advantageous position to render 
financial services to the rest of the world. More important, the

United States is at present the only country that can borrow un-

Toward an International Central Bank 339 
limited amounts in its own currency. If the dollar were replaced 
by an international currency, the United States could continue 
borrowing, but it would be obliged to repay its debt in full. At 
present, it is within the power of the U.S. government to influence 
the value of its own ipdebtedness and it is almost a foregone 
conclusion that the indebtedness will be worth less when it is 
repaid than it was at the time when it was incurred.

There are limits to the willingness of the rest of the world to 
finance the U.S. budget deficit and we may be currently approach- 
ing these limits. But the Japanese, for one, seem content to finance 
the United States even in the knowledge that they will never be 
repaid ir, full, because that is the way in which Japan can become 
"number one" in the world. Japan has already taken over the role 
of the United States as the major supplier of capital to the rest of

the world and it is only a question of time before the yen takes 
over as the major reserve currency. The transition is likely to be 
accompanied by a lot of turmoil and dislocations, as was the 
transition from the pound sterling to the dollar in the interwar 
period. 
The introduction of an international currency would avoid the 
turmoil. Moreover, it would help, arrest the decay of the U.S. 
economy currently under way. We could no longer run up exter-

nal debt on concessionary terms; therefore we would be forced to 
put our house in order. The question is whether our government 
has the foresight, and our people the will, to accept the discipline 
that an international currency would impose. Renouncing credit 
on easy terms makes sense only if we are determined to borrow 
less. That means that we must reduce both our budget and our 
trade deficits. It is at this point that the quastions of systemic

reform and economic policy become intertwined. 
As far as trade is concerned, there are two alternative ways to 
go. One is to exclude imports through protectionsist measures, 
and the other is to increase our exports. Protectionism is a recipe 
for disaster. It would precipitate the wholesale default of heavily 
indebted countries and lead to the unraveling of the international 
financial system. Even in the absence of financial calamity, the

elimination of comparative advantages would cause a substantial 
lowering of living standards throughout the world. On the other 
hand, it is difficult to see how exports can be significantly in- 
creased without systemic reform. Debt reform would increase the 
purchasing power of debtor countries and monetary reform

340 Prescription 
would provide the element of stability that is necessary for a 
t successful adjustment process in the U.S. 
It can be argued that excessive financial instability is doing 
great damage to the fabric of the American economy. Real assets 
cannot adjust to macroeconomic changes as fast as financial as- 
sets; hence there is a great inducement to transfer real assets into 
a financial form. This transfer is itself a major factor in weakening

the "real" economy. When we examine how financial assets are 
employed we gain a true measure of the devastation that has oc- 
curred. The bulk of the assets is tied up in the Federal budget 
deficit, loans to heavily indebted countries, and leveraged buy- 
outs. "Real" capital forni~eian is act.cla1l-y declinicg. That w~uld 
not be so disastrous if we could count on a steady flow of income 
I from abroad. But our trade deficit is financed partly by debt ser-

vice from less developed countries, which is precarious to say the 
least, and partly by capital inflows, which we shall have to service 
in turn. It is not an exaggeration to say that the "real" economy is 
being sacrificed to keep the "financial" economy afloat. 
To reduce our dependence on capital inflows, the budget deficit 
needs to be tackled. The most alluring prospect, in my eyes, is a 
disarmament treaty with the Soviet Union on advantageous

terms. The period of heavy defense spending under President 
Reagan could then be justified as a gigantic gamble that has paid 
off: the Imperial Circle would be replaced by a more stable config- 
uration in which both our budget and our trade are closer to 
balance. 
The Japanese can, of course, continue to produce more than 
they consume. There is nothing to stop them from becoming the 
premier economic power in the world as long as they are willing

to save and to export capital. But the rise of Japan need not be 
accompanied by the fall of the United States; with the help of an 
international currency, two leading economic powers could co- 
exist.

THE PARADOX OF SYSTEMIC REFORM 
I have provided the outlines not only of a viable international 
financial system but also of a viable economic policy for the 
United States. It is no more than a sketch or a vision but it could 
be elaborated to cover other aspects that I have not touched upon 
here. 
Two fundamental problems present themselves; one is abstract, 
and the other personal. The abstract problem concerns all at- 
tempts at systemic reform. Given our inherently imperfect under-

standing, isn't there a paradox in systemic reform? How can we 
hope to design an internally consistent system? The personal 
problem concerns my aversion to bureaucracy; awhternational 
central bank would make bureaucracy inescapable. 
I believe the paradox of systemic reform is spurious but it needs 
to be dealt with. Only if one could demand permanent and perfect 
solutions would it have any validity. But it follows from our im-

perfect understanding that permanent and perfect solutions are 
beyond our reach. Life is temporary; only death is permanent. It 
makes a great deal of difference how we live our lives; temporary 
solutions are much better than none at all. 
There is a great temptation to insist on a permanent solution. 
To understand its source, we must consider the meaning of life 
and death. The fear of death is one of the most deeply felt human

emotions. We find the idea of death totally unacceptable and we 
grasp at any straw to escape it. The striving for permanence and 
perfection is just one of the ways in which we seek to escape 
death. It happens to be a deception. Far from escaping theidea of 
death, we embrace it: permanence and perfection are death.

342 Prescription 
I have thought about the meaning of life and death long and 
1 hard and I have come up with a formulation that I have found 
personally satisfying. I shall sum it up here, although I realize 
that it may not be as meaningful to others as it is to me, The key 
is to distinguish between the fact of death and the idea of death. 
The fact of death is linked with the fact of life, whereas the idea 
of death stands in juxtaposition with the idea of consciousness.

Consciousness and death are irreconcilable; but life and death are 
not. In other words, the fact of death need not be as terrifying as 
the idea. 
The idea of death is overpowering: in terms of death, life and 
everything connected with it lose a1 significance. BQP the idea of 
death is only an idea and the correspondence between facts and 
I ideas is less than perfect. It would be a mistake to equate the idea 
and the fact. As far as facts are concerned, the clear and present

fact is that we are alive. Death as a fact looms in the distance, but, 
when we reach it, it will not be the same as the idea we have of it 
now. In other words, our fear of death is unlikely to be validated 
by the event. 
In thinking about life and death, we have a choice: we can take 
life or death as our starting point. The two are not mutually exclu- 
sive: both need to be dealt with-as a fact and as a thought. But 
the point of view we adopt tends to favor one or the other. The

bias we develop permeates all aspects of our thinking and exis- 
tence. There are civilizations, like that of the Egyptians, that seem 
to be devoted to the cult of death; there are others, like that of the 
Greeks, where even the immortals seem to lead normal lives. In 
most instances the two points of view are at odds and the inter- 
play between them makes history. The conflict between the spir- 
itual and the temporal in Christianity is a case in point. The

drama is now being reenacted in the Soviet Union where the 
demands of Communist ideology are difficult to reconcile with 
the demands of military strength and economic efficiency. 
The clash of biases can manifest itself in many more subtle 
ways. Thus, we can take different attitudes with regard to eco- 
nomic regulation. One position is that regulation is useless be- 
cause it introduces distortions that, left to themselves, eventually

lead to a breakdown of the system. This point of view is power- 
fully reinforced by the argument that the market mechanism, left 
to itself, tends toward equilibrium. The opposite point of view is 
that perfection is not attainable either by the market or by regula-

The Paradox of Systemic Reform 343 
tion. Markets are too unstable, regulation too rigid. Markets need 
to be regulated but regulation cannot be left to itself either: it is in 
constant need of revision. The fact that no system is perfect is not 
a valid argument against trying to perfect the system. Take Bretton 
Woods: the fact that it eventually broke down does not alter the 
fact that it provided tlie basis for a quarter of a century of prosper- 
ity.

ity. 
When it comes to a' choice between the two attitudes, mine is 
clearly in favor of life and the temporary and imperfect structures 
we can create within it. Although I advocate a comprehensive 
reform of the financial system, I have no illusions that the new 
system will be any more flawless or permanent than the preceding 
ones. On the contrary: I regard the search for permanence and 
perfection as an illusion. The pitfall in a well-functioning system

is that it lulls us into complacency. That is what happened to 
Bretton Woods, and that is what will happen to the next one if we 
design it too well. 
This brings me to the personal problem I have with systemic 
reform. Systems are operated by bureaucrats, and I have an in- 
stinctive aversion to the bureaucratic mentality. In advocating a 
more regulated international financial system I seem to be wish- 
ing for something that I abhor.

ing for something that I abhor. 
The problem is real. The distinctive feature of every bureau- 
cracy is its striving for self-perpetuation. Every system faces the 
danger that it becomes ossified in the hands of the bureaucracy 
that administers it. This holds true for Christianity as well as 
communism. The dead hand of bureaucracy is difficult to escape. 
Mao Tse-tung tried it by instigating the Cultural Revolution and 
the consequences were disastrous.

the consequences were disastrous. 
But the problem is not insurmountable. When bureaucrats are 
in charge of a market, market action serves to keep the bureaucrats 
on their toes. Experience shows that central banks are among the 
most flexible, innovative, and efficient institutions. The reason is 
that the market provides a criterion by which the results of their 
actions can be judged. They may come under the influence of false 
ideologies, just like anybody else, but when a policy does not

work, they cannot help but notice it. For instance, the Federal 
Reserve adopted a monetarist stance in 1979, but abandoned it in 
August 1982. Similarly, the IMF operated with a rather rigid set 
of prescriptions in dealing with heavily indebted countries, but 
gradually it has been forced to abandon a formula that does not

344 Prescription 
1 work. Central banks are often criticized for following the wrong 
policies; but the very fact that the failures can be demonstrated 
provides a potent discipline. Moreover, central banks have been 
surprisingly innovative in handling crises. The Bank of England 
invented the "lifeboat" in 1974, and the Federal Reserve applied 
it on a worldwide scale in the debt crisis of 1982. Volcker, in 
particular, proved to be a man who thrives on crises; but the fact

that a man like Volcker could be at the helm of a central bank 
cannot be treated as an accident.* 
In sum, the creation of an international central bank does not 
constitute a permanent solution. Indeed, the very idea that it con- 
stitutes a permanent solutiox carries with it the seeds of the next 
crisis. 
I 
* Compared with other bureaucracies, central banks constitute a lesser evil.

THE CRASH OF '87 
The stock market crash'of 1987 is an event of historic significance. 
One must go back to the crashes of 1929, 1907 or 1893 to find a 
comparison. In many ways the most relevant is 1929, and it is 
also the most widely hown; but in drawing the comparison we 
must be careful not to confuse the crash itself with its aftermath. 
In the crash of 1929; the New York stock market fell by about 
(36%; this figure is almost identical with the loss that occurred in

W87. Subsequently, stbcks recovered nearly half their losses, and 
then declined by another 80% in the long-drawn-out bear market 
between 1930 and 1932. It is that bear market, assoekted with the 
Great Depression, which preys on the public imagination. Exactly 
because it is so well remembered, we can be sure that history will 
not repeat itself. The immediate governmental reaction to the 
crash already bears out this contention. After 1929, :he monetary

authorities made a momentous mistake by not supplying enough 
liquidity; in the present case, they will make a different mistake. 
On the basis of their initial reaction, the danger is that they will 
destroy the stability of the dollar in their effort to avoid a reces- 
sion, at least in an election year. 
Technically, the crash of 1987 bears an uncanny resemblance 
to the crash of 1929. The shape and extent of the decline and even

the day-to-day movements of stock prices track very closely. The 
major difference is that in 1929 the first selling climax was fol- 
lowed within a few days by a second one which carried the mar- 
ket to a lower low. In 1987, the second climax was avoided, and 
even if the market were to establish new lows in the future, the

346 Prescription 
pattern would be different. The divergence bears witness to the 
I determination of the authorities not to repeat the mistake of 1929. 
In the early stages of the crash President Reagan sounded remark- 
ably like President Hoover, but by the time of his press conference 
on Thursday, October 22, he had been carefully coached to avoid 
the resemblance. 
The crash of 1987 came just as unexpectedly as the crash of 
1929. There had been a general awareness that the worldwide

boom was unsound and unsustainable, but few people got their 
timing right. I was as badly caught as the next fellow. I was con- 
vinced that the crash would start in Japan; that turned out to be 
an expensive =istake. 
In retrospect, it is easy to reconstruct the sequence of events 
t that led to the crash. The boom had been fed by liquidity; it was 
a reduction in liquidity that established the preconditions for a 
crash. In this respect also 1987 resembles 1929: it will be recalled

that the crash of 1929 was preceded by a rise in short-term money 
rates. 
Exactly how the reduction in liquidity came about in 1987 is a 
thornier question, to which one cannot give a definitive answer 
without a great deal of research. One thing is clear: the agreement 
to defend the dollar played a crucial role. In the first few months 
following the Louvre Accord of February 1987, the dollar was 
defended by sterilized intervention; that is to say, domestic inter-

est rates were not allowed to be affected. When the central banks 
found that they had to acquire more dollars than they had appe- 
tite for, they changed their tactics. After Nakasone's visit to Wash- 
ington of April 29-May 2, 1987, they allowed interest-rate 
differentials to widen to levelis a), which the private sector was 
willing to hold dollars; in effect, they "privatized" the interven- 
tion. 
What is not so clear yet is whether it was the sterilized or the

unsterilized intervention that led to the reduction in liquidity. 
Sterilized intervention transferred large amounts of dollars to the 
coffers of the central banks, and the Federal Reserve may have 
failed to inject the equivalent amounts into the domestic money 
market. In that case, the effect would have made itself felt with a 
lag of several months. Alternatively, it may be that the monetary 
authorities in Japan and Germany got cold feet about the inflation-

ary implications of unsterilized intervention and it was their at- 
tempt to rein in their domestic money supply that led to the 
worldwide rise in interest rates.

The Crash of '87 347 
I favor the latter explanation, although I cannot rule out the 
possibility that the former was also a contributing factor. The 
Germans are well known to harbor a strong anti-inflationary bias. 
The Japanese are more pragmatic, and they did, in fact, allow their 
interest rates to fall after Nakasone's return to Tokyo. But when 
they found that an easy-money policy was merely reinforcing the 
already unhealthy speculation in financial assets, including land,

they had second thoughts. They tried to slow down the growfh of 
the Japanese domestic money supply and bank lending; but spec- 
ulation was out of control by then. Even after the Bank of Japan 
started to rein in the qoney supply, the bond market continued 
to soar, and the yield on the bellwether Coupon #89 issue fell to 
only 2.6% in May before the bond market crashed in September, 
1987. 
The collapse of the Japanese bond market was the first in a

sequence of events that will enter the annals of history as the 
Crash of 1987. There were large speculative long positions in 
September bond futures which could not be liquidated. Hedging 
led to a collapse of the December futures, and the yield on the 
Coupon #89 issue rose to more than 6% before the bottom was 
reached. I thought that the collapse would carry over into the 
stock market, which was even more overvalued than the bond

market, but I was wrong. Speculative money actually moved from 
bonds to stocks in a vain attempt to recoup the losses. As a result, 
the Japanese stock market reached minor new highsin October. 
The consequences for the rest of the world were more grievous. 
The government bond market in this country had become depen- 
dent on Japanese buying. When the Japanese turned sellers, even 
in relatively small quantities, our bond market sufferad a sinking

spell which went beyond any change justified by economic fun- 
damentals. Undoubtedly our economy was somewhat stronger 
than had been expected, but the strength was in industrial pro- 
duction rather than in final demand. Commodity prices were ris- 
ing, encouraging inventory accumulation and raising the specter 
of inflation. The fear of inflation was more a rationalization for 
the decline in bonds than its root cause; nevertheless, it served to 
reinforce the downtrend in the bond market.

reinforce the downtrend in the bond market. 
The weakness in bonds widened the disparity between bond 
and stock prices that had been developing since the end of 1986. 
Such a disparity can persist indefinitely, as it did, for instance, in 
the 1960s, but as it widens it creates the preconditions for an 
eventual reversal. The actual timing of the reversal is determined

348 Prescription 
by a confluence of other events. In this case, political considera- 
t tions played a major role: President Reagan had lost his luster and 
the elections were approaching. The decisive factor was the re- 
newed pressure on the dollar; and the internal instabilities of the 
stock market converted a decline into a rout. 
The first crack came when a well-known and widely followed 
"guru," Robert Prechter, gave a bearish signal before the opening

on October 6 and the market responded with a resounding fall of 
some 90 points. This was a sign of underlying weakness, but 
similar incidents had occurred in 1986 without catastrophic con- 
sequences. The situation deteriorated when the dollar also started 
to weaken. On Tuesday, October 13, Alan Greenspan, Chairman 
of the Federal Reserve, announced that the trade balance showed 
I signs of a "profound structural improvement." The figures pub-

lished on Wednesday, October 14, were all the more disappoint- 
ing. The dollar came under severe selling pressure. The principle 
of unsterilized intervention would have required a rise in interest 
rates which would have been all the larger because of the rises 
that had occurred in Japan and Germany. The U.S. authorities 
were unwilling to undertake such a tightening, and by Thursday, 
as the stock market continued to decline, Treasury Secretary

James Baker was reported to be pressing the Germans to lower 
their interest rates lest the dollar be allowed to fall. The stock 
market decline continued to accelerate amid reports that the 
House Ways and Means Committee was planning to limit the tax 
deductibility of junk bonds issued in leveraged buy-outs. Al- 
though the provision was abandoned by Friday, stocks that had 
been bid up in the expectation of a "corporate event" declined

sufficiently to force the liquidation of positions held on margin 
by professional arbitrage traders. 
Then came the sensational lead article in the Sunday edition of 
The New York Times in which Treasury officials were reported to 
be openly advocating a lower dollar and blaming the Germans in 
advance for the stock market fall which these remarks helped to 
precipitate. Some selling pressure on Monday, October 19, was 
inevitable because of the built-in instabilities; but the New York

Times article had a dramatic effect, exacerbating the instabilities 
which had been allowed to accumulate. The result was the largest 
decline ever on a single day: the Dow Jones average lost 508 
points, or 22% of its value. 
Portfolio insurance, option writing and other trend-following 
devices allow, in principle, the individual participant to limit his

The Crash of '87 349 
risk at the cost of enhancing the instability of the system. In prac- 
tice, the breakdown of 'the system did not allow the individual to 
escape unscathed. The market became disorganized, panic set in 
and the forced liquidation of collateral further compressed market 
values. 
The collapse in ~e& York had repercussions abroad, and the 
collapse of other markets affected New York in turn. London 
turned out to be more' vulnerable than New York, and the nor-

mally staid Swiss market was even worse affected. Worst of all 
was Hong Kong, where a group of speculators in the futures mar- 
ket managed to arrange for a suspension of trading on the stock 
exchange for the rest of the week in the vain hope that they might 
be able to force a settlement of the futures contract at an artificial 
price. The ploy failed, the speculators were wiped out and the 
futures market had to be rescued by Government intervention.

During the week that the Hong Kong market was suspended, sell- 
ing from Hong Kong radiated to the other Australasian npkets 
and to London. The selling pressure persisted for the better part 
of two weeks after Black Monday. While other stock markets con- 
tinued to reach new lows, the New York market did not exceed 
the lows set in the initial selling climax. 
The only stock market that escaped collapse was Japan's. There 
was a one-day panic following Black Monday, when prices fell

the limit without many transactions taking place. (In Japan, daily 
price movements are limited by regulations.) Japanese stocks 
traded at large discounts in London the next morning; but by the 
time the Japanese market reopened the next day, the Ministry of 
Finance had made a few phone calls, the sell orders miraculously 
disappeared and large ixstitutions were aggresshe buyers. As a 
result, the market recouped a large part of the previous day's

losses. Prices sagged further after the panic, and at the time of the 
gigantic Nippon Telephone & Telegraph issue, which involved 
raising about $37 billion from the public, it looked as if the market 
might unravel. But the authorities intervened again, this time per- 
mitting the four large brokers to trade for their own accounts-in 
effect, giving them a license to manipulate the market. 
The two outstanding features of the Crash of 1987, then, are the

absence of a second selling climax in New York and the relative 
stability of Tokyo. These two features deserve further exploration, 
because they can provide some insight into consequences of the 
crash.

350 Prescription 
The historic significance of the crash of 1929 derived from the ' fact that it precipitated the Great Depression. It occurred during a 
period when economic and financial power was moving from 
Europe to the United States. The shift in power caused a great 
deal of instability in exchange rates, and the end result was that 
the dollar supplanted sterling as the international reserve cur- 
rency; but the crash of 1929 itself played no clearly defined role 
in the process.

in the process. 
By contrast, the historic significance of the Crash of 1987 lies 
in the fact that it marks the transfer of economic and financial 
power from the United States to Japan. Japan has been producing 
more than it consumes, t;nd the Ucitsd States has been consuming 
more than it produces for some time past. Japan has been accu- 
I mulating assets abroad, while the United States has been amass- 
ing debts. The process received a great boost when President

Reagan took office with a program of cutting taxes and increasing 
military expenditures (in this context, armaments are also a form 
of consumption), and it has been gaining momentum ever since. 
Both sides have been loath to acknowledge it: President Reagan 
wanted to make Americans feel good about being American and 
pursued the illusion of military superiority at the cost of render- 
ing our leading position in the world economy illusory; while

Japan wanted to keep growing in the shadow of the United States 
as long as possible. 
The Crash of 1987 has revealed the strength of Japan and made 
the transfer of economic and financial power clearly visible. It 
was the collapse of the Japanese bond market that depressed our 
own bond market and set up our stock market for a crash. Yet 
Japan has been able to avert 3 collapse of its own stuck markst. 
To top it all, our authorities have been able to avert a second

selling climax only by abandoning the dollar. Herein lies the sig- 
nificance of the two features of the crash I have singled out for 
special attention. Japan has, in effect, emerged as the banker to 
the world-taking deposits from the rest of the world, and making 
loans to and investing in the rest of the world. The dollar is no 
longer qualified to serve as the international reserve currency. 
Whether a new international currency system can be established

without a Great Depression remains an open question. 
Events are notoriously more difficult to predict than to explain. 
How can one anticipate decisions that have not yet been taken? 
Nevertheless, one can evaluate the implications of the decisions 
that have already been taken.

The Crash of '87 351 
The Crash of 1987 confronted our Government with the ques- 
tion: which do we conSider more important, averting a-recession 
or preserving the value of the dollar? The response was unequiv- 
ocal. By the middle of the second week after Black Monday, the 
dollar had been cut loose from its moorings, and by the end of 
that week Treasury Secretary James Baker made the news official. 
The dollar moved obediently lower, and a second selling climax

in the stock market did not take place. The mistake of 1929 has 
been avoided, but only at the peril of committing a different kind 
of mistake. The decision to cut the dollar loose is painfully remi- 
niscent of the competitive devaluations of the 1930s. Temporary 
relief may be bought at ,the cost of greater damage later. 
Prospects are good that a severe recession in the United States 
can be avoided at least in the near future. Consumer spending was

already declining prior to the crash, and the crash is bound to 
make consumers more cautious. But industrial production has 
been benefiting from the lower dollar, and industrial employment 
has been strong. The reduction in the budget deficit is too small 
and too illusory to have much of an effect. If American corpora- 
tions slash their capital expenditures, foreign corporations ex- 
panding in the United States may take up the slack. It is unlikely,

therefore, that the downturn in consumption would develop into 
much more than a flat first quarter or first half in 1988. Both 
Germany and Japan are likely to stimulate their own economies. 
The net result would be a continuation of the slos growth that 
has prevailed in the world economy since 1983. It may come as a 
surprise how little direct effect the stock market is going to have 
on the real economy. 
The trouble with this scenario is that it leaves the imbalances

that have precipitated the Crash of 1987 unresolved. Neither the 
budget deficit nor the trade deficit of the United States is likely to 
disappear. The aftermath of the crash may bring some temporary 
respite, but eventually the dollar is bound to come under pressure 
again-either because our economy is strong and the trade deficit 
persists, or because it is weak and lower interest rates are needed 
to stimulate it. 
The United Kingdom found itself in a similar situation prior to

the discovery of North Sea oil. The result was "stagflation" and a . sequence of "stop-go" policies. The same is in store for us now. 
The major difference is that the United States is the largest econ- 
omy in the world and its currency still serves as the international 
medium of exchange. As long as the dollar remains unstable, in-

352 Prescription 
ternational financial markets will remain accident-prone. It ' should be recalled that while it was the Louvre Accord that cre- 
ated the preconditions for a crash, it was the actual fall in the 
dollar that precipitated it. 
If the dollar continues to depreciate, owners of liquid assets 
will be driven to take refuge elsewhere. Once the movement gath- 
ers momentum, not even a rise in interest rates could arrest it,

because the rate of depreciation in the dollar would outweigh the 
interest-rate differential in its favor. Eventually, the rise in inter- 
est rates would bring on a more severe recession than the one that 
the Administration sought to avoid. 
It has happened before. In the last tvro years ~f the Carter Ad- 
ministration, speculative capital continued to move to Germany 
I and Switzerland even when it had to pay a premium to be ac-

cepted there. The specter of a free-fall in the dollar is more real 
today than it has been at any time since President Carter was 
forced to sell bonds denominated in hard currencies in 1979. 
Ever since the crash, stock markets worldwide have weakened 
whenever the dollar weakened, and vice versa. The message is 
clear: any further decline in the dollar would be counterproduc- 
tive. The Administration seems to have received the message: all

talk of a lower dollar has ceased, and now that a budget compro- 
mise of sorts has been accomplished, preparations are under way 
for reestablishing the Louvre Accord. Much depends on how suc- 
cessful the effort will be. Unfortunately, the Administration does 
not bring much to the table: the budget cut has been described as 
"a miserable pittance" by Senator Packwood. Moreover, the Crash 
of 1987 has demonstrated conclusively that the Administration is

more concerned with avoiding a recession than with stabiiizing 
the dollar. The burden of supporting the dollar will fall primarily 
to our trading partners. 
The best way for the Japanese to protect their export markets is 
to transfer production to the dollar zone; the process had already 
started prior to the crash. Many Japanese companies, led by the 
car makers, are establishing manufacturing subsidiaries in the 
United States and Mexico. The process will be accelerated by

the crash and the falling dollar, both of which make American 
assets cheaper to acquire and the American market less profitable 
to supply from abroad. The eventual solution of the trade deficit 
will be import substitution-by Japanese manufacturers. It 
echoes the solution to Europe's seemingly incurable "dollar gap"

The Crash of '87 353 
after the Second World War. That was the time when many Amer- 
ican corporations became "multinational" and the United States 
consolidated its hegemony over the world economy. Similarly, 
the birth of Japanese multinational corporations will coincide 
with Japan's becoming the world's banker and economic leader. 
Already, large-scalk Japanese investments give Japan consider- 
able political leverage in the United States. Almost every state in

the Union has establibhed trade-promotion offices in Japan. Their 
endeavors are not likely to make much headway if the Congress- 
men representing the state are too vocal in supporting protection- 
ist measures. In spite of all the posturing, protectionism may no 
longer be a viable policy option. And in a few years' time, when 
the Japanese have built their factories, they may become the most 
ardent protectionists-to keep out competition from Korea and 
Taiwan.

Taiwan. 
There have been many instances in the course of history when 
economic and financial and, eventually, political and military 
leadership passed from one country to another. The latest in- 
stance was in the interwar period, when the United States sup- 
planted Great Britain. Nevertheless, the prospect of Japan's 
emerging as the dominant financial power in the world is very 
disturbing, not only from the point of view of the United States

but also from that of the entire Western civilization. 
From the narrowly American standpoint, the damage is too ob- 
vious to deserve much elaboration. The loss of our preeminent 
position is bound to engender a crisis in our sense of national 
identity. Having just expended enormous sums in the pursuit of 
military superiority, albeit these sums were borrowed abroad, we 
are ill prepared to cope with the fact that we are losing our eco-

nomic superiority. Our sense of national identity is less firmly 
grounded in tradition than in the case of Great Britain, so the 
crisis is bound to be all the more deeply felt. The consequences 
for our political behavior, both internally and internationally, are 
incalculable. 
The implications for our civilization are equally profound but 
less obvious. The international trading system is an open system;

its members are sovereign states which have to treat each other . on the basis of equality. That would not change if Japan takes over 
leadership. On the contrary, the Japanese can be expected to step 
more gingerly than the Americans have on occasion.

3 54 Prescription 
The problem is more subtle. The United States and Great Brit- 
t ain are members of the same culture; that is not true of Japan. The 
Japanese have shown tremendous capacity to learn and to grow, 
but the society in which they live remains fundamentally differ- 
ent from ours. The Japanese think in terms of subordination and 
dominance. Contrast this with the notion that all men are created 
equal, and the difference between the two cultures is brought into 
focus.

focus. 
Both the United States and Great Britain are open societies: 
internally, people enjoy a large degree of freedom; externally, the 
borders are open to the movement of goods, people, capital and 
ideas to various degrees. Japan is still, to a large extent, a closed 
society. The features of an open society, such as a democratic 
I fom of government, have been imposed by an occupying power 
after a lost war. But the value system which permeates Japanese

society is a closed one: the interests of the individual are subor- 
dinated to the interests of the social whole. 
This subordination is not achieved through coercion; Japan 
bears no resemblance whatsoever to a totalitarian state. It is 
merely a country with a very strong sense of national mission and 
social cohesion. The Japanese want to be part of a group that 
strives to be number one, whether it is their company or their

nation; and they are willing to make considerable sacrifices in the 
service of that goal. They cannot be faulted for holding such val- 
ues; indeed, it is more appropriate to criticize Americans for their 
unwillingness to suffer any personal inconvenience for the com- 
mon good. Japan is a nation on the rise; we have become deca- 
dent. 
The question is, whether the United States in particular and tha 
rest of the world in general will allow itself to be dominated by

an alien society with such a strong sense of national identity. The 
question is troubling not only for us but also for the Japanese. 
There is a strong school of thought that wants Japan to open up 
in order to become more acceptable to the rest of the world. But 
there is also a strong commitment to traditional values and an 
almost pathological fear, especially in the older generation, that 
Japan may lose its drive before it becomes number one. Japan is a

society in transition, and it may well become much more open as 
it assumes the role of leadership. There are many internal ten- 
sions and contradictions which tend to undermine social cohe- 
sion and hierarchical values. Much depends on how fast the

The Crash of '87 355 
transition occurs. If, the United States proved itself somewhat 
more viable than it has been of late, the value system of an open 
society would also become more attractive to the Japanese. 
The closed character of Japanese society manifests itself in 
many areas. Formally a democracy, Japan has been ruled by one 
party since its present constitution was introduced; the succes- 
sion of prime mini4ters is determined by negotiations behind

closed doors. Although the domestic market is formally open, 
foreign companies find it impossible to penetrate it without a 
domestic ally. But nowhere is the difference between the open- 
ness of the Western system and the closed character of the Japa- 
nese more dramatidally demonstrated than in the financial 
markets. 
The Western world has gone overboard in allowing financial 
markets to function unhindered by any government regulation.

That was a grievous mistake, as the Crash of 1987 has demon- 
strated. Financial markets are inherently unstable; stability can 
be maintained only if it is made an objective of public policy. 
Instability is cumulative. As I have tried to show elsewhere in 
this book, the longer markets are allowed to develop without reg- 
ulation, the more unstable they become, until eventually they 
crash. 
The Japanese attitude toward financial markets is totally differ-

ent. The Japanese treat markets as a means to an end and manip- 
ulate them accordingly. The authorities and ttfe institutional 
players are connected by a subtle system of mutual obligation. 
Recent events have provided an insight into the way the system 
operates. The first time the market was set to collapse, after Black 
Monday, a telephone call from the Ministry of Finance was suffi- 
cient to rally the financial institutions. In the second instance, at

the time of the public issue of Nippon Telephone & Telegraph 
shares, financial institutions proved less responsive, perhaps be- 
cause the Ministry of Finance had used up its chits in the first 
phone call. It now had to rely on the brokers, whose survival was 
directly threatened. By giving them license to manipulate the 
market, the authorities avoided disaster. 
Whether a collapse can be avoided indefinitely is one of the 
most fascinating questions about the current financial situation.

It still awaits an answer. The authorities have allowed a specula- 
tive bubble to develop in Tokyo real estate and in the stock mar- 
kets whose magnitude has few parallels in history. To illustrate,

356 Prescription 
, Nippon Telephone & Telegraph shares were sold to the public at 
270 times earnings, while American Telephone & Telegraph was 
valued at 18 times. If this were a free market, it would have col- 
lapsed already. There has been no example in history when a 
bubble of this magnitude has been deflated in an orderly manner 
without bursting. The authorities have been unable to prevent a 
crash in the Japanese bond market, but they may be able to do so

in the stock market. The continuing strength of the yen works to 
their advantage. If they succeed, it would represent a historic first, 
the dawn of a new era in which financial markets are manipulated 
, for the benefit of the public good. 
The effect of the crash was to move the Japanese stock market 
nearer to being a closed system. Foreigners owned less than 5% 
I of Japanese stocks at the outset of the crisis, and they dumped

much of their stock during and after it. The selling was absorbed, 
interestingly, not so much by Japanese institutions as by the Jap- 
anese public, which was encouraged by the brokers to go heavily 
into debt. Japanese brokers did, in fact, speak of buying stocks 
during the crisis as a patriotic duty whose accomplishment will 
set Japan apart from the rest of the world. Margin debt is at an all- 
time record. How to reduce the debt load without precipitating

forced liquidation of margin accounts is the task now confronting 
the authorities. 
Why did the Japanese authorities allow the speculative bubble 
to develop in the first place? That is another fascinating question 
about which one can only conjecture. There were external pres- 
sures-the United States was pushing for lower interest rates in 
Japan-but the Japanese would not have yielded if it had not 
suited them. 
At first, the inflation of financial assets allowed the authorities

to discharge their obligations toward the commercial banks at a 
time when the real economy was in deep trouble. Without the 
land and stock market boom, the commercial banks would have 
seen many of their loans to industrial companies turn sour, and 
their earnings would have suffered. Land and stock market spec- 
ulation allowed them to expand their loan portfolios against 
seemingly good collateral and also allowed the industrial com-

panies to make up for their earnings shortfall by earnings derived 
from "zaitech"-that is, financial manipulation. The land boom 
has also served another purpose: it helped to preserve a high 
domestic savings rate and a favorable trade balance in spite of the

The Crash of '87 357 
rise in the value of the yen. With the cost of housing rising faster 
than wages, Japanese wage earners had good reason to save an 
increasing portion of their income. With the domestic economy 
in recession, the savings were available for investing abroad. That 
was an ideal recipe for amassing wealth and power in the world, 
even if the foreign investments depreciated in value. I suspect 
that at least a fractioniof the Japanese power elite would be quite

pleased to see investors lose some money: it would prevent the 
Japanese from going soft before Japan has become great. How else 
can one explain the willingness of a democratic government to 
sell shares to its electorate at obviously inflated prices? 
But rising land and' stock prices soon started to have adverse 
consequences. The high savings rate brought additional pressure 
from abroad to stimulate the domestic economy, and the govern-

ment finally had to give in. Moreover, the gap between those who 
owned land and those who did not widened to such an extent as 
to threaten social cohesion. As soon as the domestic economy 
began to recover, there was no need to allow banks to finance 
speculative transactions; on the contrary, it was appropriate to 
redirect their resources toward the real economy. The attempt to 
rein in bank lending and the money supply set off the chain of 
events I have reviewed earlier.

events I have reviewed earlier. 
It is ironic that the Japanese should have a better understanding 
of the reflexive character of the financial markets than the Western 
world does, and it is regrettable that they shou1ct"be using it to 
ensure the success of a closed system. If we don't like what is 
happening, we should take steps to develop a viable alternative. 
The stock market boom has diverted our attention from the 
fundamental deterioration in the financial position of the United

States. With the frenetic activity in financial markets and the lure 
of quick rewards, it was at least possible to pretend that the poli- 
cies pursued by the Reagan Administration were working. The 
Crash of 1987 comes as a rude awakening. Many of the profits 
turned out to be illusory, and frenetic activity will soon be suc- 
ceeded by the stillness of the morgue. Prospects are dismal. One 
way or another, we face a reduction in living standards. Much 
will depend on the route we choose.

will depend on the route we choose. 
The most likely path is the one I have outlined earlier. It is the 
path followed by Great Britain before us, and it is likely to pro- 
duce similar results as far as the United States is concerned. The

358' Prescription 
effect on the world economy may be much more negative because 
of the importance of the dollar. 
There is also a temptation to pursue a protectionist policy, but 
for the reasons I have stated earlier, it is no longer a viable alter- 
native. Nevertheless, it could do a lot of mischief. 
Finally, there is the possiblity of reasserting the leadership we 
failed to exercise. This would involve not only putting our own

house in order but also bringing a new international financial 
order into existence which is appropriate to the altered circum- 
stances. 
We cannot have a smoothly functioning international economy 
without a stable international currency. The monetary authorities 
began to recognize this fact with the Plaza Agreement of October 
4 1985 and reconfirmed it with the Louvre Accord of February 
1987. Unfortunately, the steps they took were inadequate, and the

Louvre Accord fell apart in the Crash of 1987. Since the decision 
to stabilize the dollar can be held responsible, one way or another, 
for the crash, it is highly unlikely that the Louvre Accord can be 
patched up. Whatever agreement is reached, its credibility will 
have been diminished by the fact that when it came to the crunch, 
the previous agreement had been abandoned. And it is highly 
doubtful whether the Louvre Accord should be patched up-after 
all, it did cause the Crash of 1987.

all, it did cause the Crash of 1987. 
Trying to protect the currency at an unsustainable level can 
plunge the country into protracted depression; that is what hap- 
pened to Great Britain in 1926 when it returned to the gold stan- 
dard at the prewar level. 
It could be argued that the dollar is reasonably valued at 
DM1.65 and Y132 to the dollar. This is true in the sense that a 
further fall in its value would not bring any appreciable improve-

ment in the trade balance in the near term. But this was already 
true when the dollar was 10% higher. The reason is that the ad- 
justment process takes time, while a fall in the value of the cur- 
rency has an immediate negative impactqthe famous J-curve 
effect). Moreover, the more unstable the exchange rate, the more 
reluctant people are to make the investments necessary to adjust 
to it. 
The argument only goes to prove that there is simply no realis-

tic exchange rate at which the dollar can continue fulfilling its 
role as the international reserve currency: the dollar is unsound 
at any price. Holders of financial assets seek the best store of

The Crash of '87 359 
value, and the dollar no longer qualifies. A country with a large 
budget deficit and a large trade deficit cannot expect foreigners to 
accept an ever-increasing flow of its currency. Yet the interna- 
tional financial system cannot function without a stable currency 
as its foundation. This is the central lesson that emerges from the 
Crash of 1987. 
We desperately neqd an international currency system that is

not based on the dollar. Yet the yen is not yet ready to serve as 
the international reserve currency-partly because the Japanese 
financial markets are not sufficiently open, and partly because the 
rest of the world is not ready to accept Japanese hegemony. The 
ideal solution would be a genuine international currency, issued 
and controlled by a genuine international bank. International 
lending for balance-of-payments purposes would then be desig-

nated in the international currency, and the value of the currency 
would be tied to gold br to a basket of commodities, ensuring that 
debts would have to be repaid in full. Only when the dollar loses 
its privileged status will the United States cease to flood the world 
with dollars. The sooner we make the transition, the better the 
chances of arresting the economic decline of the United States. 
Unfortunately, we are not yet ready to learn the central lesson

of the crash. The prevailing wisdom still maintains that markets 
are self-correcting and exchange rates ought to be allowed to find 
their equilibrium levels. The Crash of '87 has, if anything, rein- 
forced this line of thought. As a consequence, wcan expect a 
period of continuing turmoil in financial markets, although the 
focus of attention may shift from the stock market to the currency 
market and the bond market and, eventually, to the market for 
precious metals.

precious metals. 
The idealof an international currency and an international cen- 
tral bank hgs few supporters. Ironically, it is likely to get a more 
enthusiastic response in Japan than in the United States. There 
are many people in Japan who would like their country to de- 
velop into a more open society. The Japanese have still vivid 
memories of the Second World War when they tried to go it alone. 
They would much rather flourish within a worldwide trading and

financial system than embark on the impossible task of creating 
their own. As newcomers, they would be willing to accept an 
arrangement that does not fully reflect their current strength. 
Yet it is the United States that has the most to gain from a 
reform of the international currency system. It would allow us to

360 Prescription 
I consolidate our position in the world which we are otherwise in 
danger of losing. We are still in a position to strike a favorable 
deal, especially in view of our military might. Most important, we 
could preserve an open system in which Japan would be one of 
the leading members, becoming a more open society in the pro- 
cess. The alternative is a period similar to the 1930s: finan- 
cial turmoil, beggar-thy-neighbor policies leading to worldwide

EPILOGUE I 
The unifying theme of this book is the concept of reflexivity. I 
have focused on its implications for the social sciences in general 
and financial markets in particular. I have left other areas largely 
unexplored. I should like to mention them briefly here, although 
my thoughts relating to them are not properly developed. They 
ought to form the subject of another book in the future, but I am 
afraid I may not have a chance to write it, especially if I remain

involved in financial markets. 
First, the question of values. Economic theory has trained us to 
take values as given, although the evidence sugge~~that they are 
shaped by a reflexive process. Most values can be reduced to 
economic terms nowadays-the most recent Nobel laureate in 
economics earned his prize by interpreting politics as an eco- 
nomic process in which the participants seek to maximize their 
own benefits-but that has not always been the case, and even

today there are many parts of the world where profit-maximizing 
behavior takes second place to other motivations. Religion and 
tradition are less easily amenable to economic analysis than is 
politics in a materialistic culture. We have great difficulty in un- 
derstanding a phenomenon like Islamic fundamentalism; at the 
other end of the scale, a movement that we profess to admire, 
Solidarity, is also alien to our way of thinking.

The predominance of economic values in Western and western- 
ized societies is itself a function of our economic success. Values 
evolve in reflexive fashion: the fact that economic activity has 
borne positive results has enhanced the value we put on eco-

362 Epilogue 
I nomic values. The same can be said about scientific method: the 
triumphs of natural science have raised the status of scientific 
method to unsustainable heights. Conversely, various forms of art 
have played a much bigger role in cultures not very far removed 
from our own just because it was easier to achieve positive results 
in art than in economic activity. Even today, poetry carries a 
weight in Eastern Europe, including the Soviet Union, that we

find difficult to appreciate in the West. There is little doubt in my 
mind that our emphasis on material values, profit, and efficiency 
has been carried to an extreme. 
Reflexive processes are bound to lead to excesses, but it is im- 
possible to define what is excessive because in matters of values 
there is no such thing as normal. Perhaps the best way to ap- 
t proach the subject of values is to start from the position that they

are rooted in fantasy rather than reality. As a consequence, every 
set of values has a flaw in it. We can then ask what are the ele- 
ments of fantasy in a particular set of values and how the ele- 
ments of fantasy and reality have interacted. Any other approach 
would introduce a bias in favor of our own flawed set of values. 
Values are closely associated with the concept of self-a reflex- 
ive concept if ever there was one. What we think has a much

greater bearing on what we are than on the world around us. What 
we are cannot possibly correspond to what we think we are, but 
there is a two-way interplay between the two concepts. As we 
make our way in the world our sense of self evolves. The relation- 
ship between what we think we are and what we are in reality is 
the key to happiness-in other words, it provides the subjective 
meaning of life. 
I could readily provide a reflexive interpretation of my own

development but I am reluctant to do so because it would be too 
revealing, not to say incriminating. It will come as no surprise to 
the reader when I admit that I have always harbored an exagger- 
ated view of my self-importance-to put it bluntly, I fancied my- 
self as some kind of god or an economic reformer like Keynzs 
(each with his General Theory) or, even better, a scientist like 
Einstein (reflexivity sounds like relativity). My sense of reality

was strong enough to make me realize that these expectations 
were excessive and I kept them hidden as a guilty secret. This 
was a source of considerable unhappiness through much of my 
adult life. As I made my way in the world, reality came close 
enough to my fantasy to allow me to admit my secret, at least to

Epilogue 363 
myself. Needless to Fay, I feel much happier as a result. I have 
been fortunate enough to be able to act out some of my fantasies 
-this book, in particular, fills me with a great sense of accom- 
plishment. Reality falls far short of my expectations, as the reader 
can readily observe, but I no longer need to harbor a sense of guilt. 
Writing this book, and especially these lines, exposes me in a way 
I never dared to expqse myself before, but 1 feel I can afford it: my

success in business protects me. I am free to explore my abilities 
to their limits, exactly because I do not know where those limits 
are. Criticism will help me in this endeavor. The only thing that 
could hurt me is if my success encouraged me to return to my 
childhood fantasies of omnipotence-but that is not likely to hap- 
pen as long as I remain engaged in the financial markets, because 
they constantly remind me of my limitations. Given my person-

ality I have been extremely lucky in my career choice, but of 
course it was not really a choice but a reflexive process in the 
course of which both my career and my sense of self evolved in 
tandem. I could say a lot more on the subject, but as long as I have 
a career in business I have to plead the Fifth Amendment. There 
is a point beyond which self-revelation can be damaging and one 
of the flaws in my character, which I have not fully fathomed, is

the urge to reveal myself. Perhaps I was exaggerating a minute ago 
when I said I am not afraid of exposing myself. 
I also have some views on what could be called the meaning of 
life in the objective sense-if it were not a contradtiction in terms 
to use the word "objective" in this context. I start from the posi- 
tion that every human endeavor is flawed: if we were to discard 
(everything that is flawed there would be nothing left. We must

therefore make the most of what we have; the alternative is to 
embrace death. The choice is a real one, because death can be 
embraced in a number of ways; the pursuit of perfection and 
eternity in all its manifestations is equivalent to choosing the idea 
of death over the idea of life. If we carry this line of argument to 
its logical conclusion, the meaning of life consists of the flaws in 
one's conceptions and what one does about them. Life can be seen 
as a fertile fallacy.

as a fertile fallacy. 
So far I have spoken mainly in terms of the individual. But the 
individual does not exist in isolation; his inherently imperfect 
understanding makes him all the more dependent on the society 
to which he belongs. The analysis that has led to the concept of 
reflexivity also throws some light on the relationship between the

3 64 Epilogue 
, individual and society. It is a mistake to think that there are two 
separate entities involved: the relationship is between a part and 
a whole. We have seen the cognitive difficulties that such a rela- 
tionship gives rise to: neither the individual nor society can be 
defined without reference to the other. Given the structure of our 
language it is extremely difficult to recognize the contingent na- 
ture of the two entities, and as a matter of historical fact most

discourses on the subject have taken either the whole or the part 
as their starting point. The choice of the starting point tends to 
infuse the rest of the discussion with a bias. The famous speech 
of Agrippa in which he compares society with an organism epit- 
omizes one extreme, and Rousseau's social contract the other. 
In order to avoid the bias inherent in these extremes new cate- 
t gories of speech need to be established. An appropriate language

is beginning to emerge in the context of computer science and 
systems analysis, but it will take time to permeate general dis- 
course.* Even if we learn to think in terms of reflexive and recur- 
sive relations, we are confronted with a substantive choice: 
should society take a predetermined shape or should its members 
be allowed to determine the form of society in which they live? 
The former kind of society has been described by Karl Popper as 
closed, the latter as open.

closed, the latter as open. 
I have just come back from China where the issue is of vital 
significance. The country has passed through a horrendous period 
during which the collective terrorized the individual on a mas- 
sive scale. It is now run by a group of people who had been on 
the receiving end of the terror. These people have ample reason 
to be passionately devoted to the cause of individual freedom; but 
they are up against a long tradition of feudalism, an all-pervasive

bureaucracy, and the constraints of Marxist ideology. 
I was surprised to find an avid interest in the concept of reflex- 
ivity. As I have noted in the book, reflexivity could also be de- 
scribed as a kind of dialectics, but I have eschewed using the word 
because of the heavy intellectual baggage it carries. It is exa$ly 
these connotations that make the concept so fascinating for the 
Chinese because it allows them to modify Marxist ideology with-

out breaking with it. Hegel propounded a dialectic of ideas; Marx 
* I have been much taken by Gregory Bateson, Steps to an Ecology of Mind (New 
York: Ballantine, 1975), and Douglas R. Hofstadter, Godel, Escher, Bach: An 
Eternal Golden Braid (New York: Basic Books, 1979).

Epilogue 365 
turned the idea on it$ head and espoused dialectic materialism; 
now there is a new dialectic that connects the participants' think- 
ing with the events in which they participate-that is, it operates 
between ideas and material conditions. If Hegel's concept was the 
thesis and Marxism the antithesis, reflexivity is the synthesis. 
But there is a fundamental difference between Marxism and the 
new dialectic. Marx lpbored under the misapprehension that, in

order to be scientific, a theory has to determine the future course 
of history. The new dialectic is emphatically not deterministic. 
Since the shape of society cannot be "scientifically" determined, 
it must be left to the participants to decide their own form of 
organization. Since nt, participant has a monopoiy on truth, the 
best arrangement allows for a critical process in which conflicting 
views can be freely debated and eventually tested against reality.

Democratic elections provide such a forum in politics, and the 
market mechanism provides one in economics. Neither markets 
nor elections constitute an objective criterion, only an expression 
of the prevailing bias; but that is the best available in an imperfect 
world. Thus, the concept of reflexivity leads directly to the con- 
cept of an open society-hence its "charm" in contemporary 
China. As far as I am concerned, it completes what Hofstadter

would call a "recursive loop" between my concept of reflexivity, 
my interest in financial markets, and my devotion to the ideal of 
an open society. 
m-

NOTES 
Introduction 
1. Karl R. Popper, The Poverty of Historicism (London: Routledge & 
Kegan Paul, 1957), p. 130. 
Chapter 3 
1. George Stigler, Theory of Price (New York: Macmillan, 1966). 
2. Lionel C. Robbins, An Essay on the Nature and Significance of Eco- 
nomic Science, 3d. ed. (New York: New York University Press,1984). 
3. Karl R. Popper, The Logic of Scientific Discovery (New York: Basic 
Books, 1959), and Conjectures and Refutations (London: Routledge 
& Kegan Paul, 1963).

& Kegan Paul, 1963). 
4. Karl R. Popper, The Poverty of Historicism (London: Routledge & 
Chapter 3 
1. Ragnar Nurske, International Currency Experience: Lessons of the 
Interwar Period (Geneva: League of Nations, Secretariat; Economic, 
Financial, and Transit Department, 1944). 
2. Henry Kaufman, "Comments on Credit," May 3, 1985 (New Pork: 
Salomon Brothers Inc.). 
Chapter 5 
1. The New York Times (April 21, 1985).

1. The New York Times (April 21, 1985). 
2. Milton Friedman and Anna Schwartz, A Monetary History of the 
United States, 1867-1960 (Princeton: Princeton University Press,

Notes 367 
1963), and Monetary Statistics of the United States (New York: 
Columbia University Press, 1970). 
Chapter 6 
I. George Soros, "The ~kternational Debt Problem, Diagnosis and Prog- 
nosis," July 1983; ':The International Debt Problem Revisited," 
March 1984 (New Yotk: Morgan Stanley). 
2. Anatole Kaletsky, The Costs of Default (New York: Twentieth 
Century Fund, 1985). 
Chapter 7 
1. Henry Kaufman, loc. cit., passim. 
2. For example, Paul Volcker's testimony before the Senate Banking

Committee, February 20,1986. 
Chapter 8 
I. International Monetafy Fund, World Economic Outlook (September 
1, 1986). 
2. Jonathan E. Gray, "Financial Corporation of America: Strategic Anal- 
ysis # Forecast," Bernstein Research, Dec. 28,1983 (New York: San- 
ford C. Bernstein & CQ.). 
Chapter 18 x.- 
1. The International Parliamentary Working Round Table on Exchange 
Rates and Coordination, Zurich, Switzerland; June 28, 29, and 30, 
1986.

1986. 
2. The U.S. Congressicnal Summit on Debt and Trade, New York, N.Y.; 
Dec. 3,4, and 5, 1986.

APPENDIX 
PROSPECT FOR 
EUROPEAN DISINTEGRATION 
I am very grateful to the Aspen Institute for giving me this oppor- 
tunity to address an audience in Germany, and I have chosen a 
topic which ought to be of particular interest to people in Germany. 
My topic is the prospect of European disintegration. 
It is a subject that engages me in three different ways. First, I am 
passionately devoted to the idea of Europe as an open society. Sec-

ond, I have developed a theory of history which casts light on the 
process of European integration and disintegration. Third, I am a 
participant in the process. 
Open society means a society based on the idea that nobody has a 
monopoly on truth; a society which is not dominated by the state or 
by any particular ideology, where minorities and minority opinions 
are respected. Using these criteria, the ~uro~ean Community is a 
highly desirable form of organization. Indeed, in some ways it is

ideal, because it has a very interesting feature: all the participating 
states are in a minority. Respect for the minority is the basis of its 
construction. The unresolved question is: how much power should 
be delegated to the majority? How far should Europe be integrated? 
The way Europe evolves will have a profound influence on what 
happens to the east of Europe, the region that was formerly under 
the sway of Communist ideology. Communism built a universal

closed society, but Communism as an ideology is now well and 
truly dead. The line of least resistance leads to the break-up of the 
universal closed system into particular closed societies, based on

Appendix 369 
the principle of national or ethnic identity. We can see the principle 
well advanced in the former Yugoslavia. The only possible escape 
from this fate is to make the transition from closed to open society. 
But that is not so easy. It requires time and effort to establish the 
rule of law, the institutians of civil society, and the critical way of 
thinking which are characteristic of an open society. Societies dev- 
astated by Communism Gannot make the transition on their own.

They need a Europe that is open and receptive and supportive of 
their effort. East Germany got too much help, the rest of Eastern 
Europe too little. I am deeply engaged in helping the rest of Eastern 
Europe. As you may knoiv, I have set up a network of foundations 
devoted to this cause, and that is the bias that I bring to the subject 
of Europe. 
My second involvement is that I have developed a theory of his- 
tory which has guided me both in my activities in the financial mar-

kets and in setting up the foundation network. The key to my theory 
is the role that mistakes and misconceptions play in shaping the 
course of events. Thereis, always a divergence between the partici- 
pants' thinking and the actual state of affairs, but sometimes the 
divergence is relatively small and self-correcting-I call this "near- 
equilibrium"; and, at other times, the divergence is large, with no 
tendency to correct itself-I call this "far-from-equilibrium." The

course of events has quite a different character in near-equilibrium 
and in far-from-equilibrium conditions. This point is not generally 
und&stood. My theory relates to far-from-equilibriuG conditions. 
I have made a particular study of what I call the "boom/bust se- 
quence," which can be observed from time to time in financial mar- 
kets; and I think it is also applicable to the integration and 
disintegration of the European Community. Since the revolution of

1989 and the reunification of Germany, Europe has been in a condi- 
tion of dynamic disequilibrium. Therefore it presents a very inter- 
esting case study for my theory of history. 
And, finally, I am myself a participant in this process of dynamic 
disequilibrium because I am an international investor. I used to call 
myself a speculator and I used to joke that an investment is a spec- 
ulation that has gone wrong but, in view of the campaign against

speculators, I am no longer amused. International investors did 
play an important role in the breakdown of the Exchange Rate 
Mechanism, but it is impossible to have a common market without 
international capital movements. To blame speculators is like 
shooting the messenger.

370 Appendix 
I I shall deal with my subject on the basis of my theory of history. 
The fact that I am also a participant does not interfere with my abil- 
ity to apply the theory. On the contrary, it has allowed me to test it 
in practice. Nor does it matter that I bring a particular bias to the 
subject because it is part of my theory that participants in a histor- 
ical process always act on the basis of a bias. And, of course, the 
same rule applies to the proponents of theories.

same rule applies to the proponents of theories. 
But I must confess that my particular bias-namely, that I want 
to see a united, prosperous and open Europe--does interfere with 
my activities as a participant in financial markets. I had no problem 
as long as I was an anonymous participant. Sterling would have left 
the ERM whether or not I speculated against it. But, after sterling 
left the ERM, I received a lot of publicity and I ceased to be an

4 anonymous participant. I became a guru. I could actually influence 
the behavior of markets, and it would be dishonest of me to pretend 
otherwise. This has created opportunities and imposed responsi- 
bilities. Given my bias, I did not want to be responsible for the 
French franc being pushed out of the Exchange Rate Mechanism. I 
decided to abstain from speculating against the franc in order to be 
able to put forward a constructive solution; but nobody thanked me

for it. Indeed, my public utterances seemed to annoy the monetary 
authorities even more than my activities in the financial markets, 
so I can't say I am doing well in my newfound role of guru. Never- 
theless, given my bias, I must say what I am going to say, even if it 
is inconvenient for me as a participant. 
The important point about my boom/bust theory is that there is 
nothing inevitable about it. The typical boom/bust sequence is ini-

tially self-reinforcing and, eventually, self-defeating, but it can be 
aborted or diverted at any point. It is in the light of this theory that 
I shall comment on the boom/bust process of European integra- 
tion. I shall pay particular attention to the Exchange Rate Mecha- 
nism, which is playing such a crucial role in the process. It had 
worked perfectly well in near-equilibrium conditions, until the re- 
unification of Germany. But the reunification has created condi-

tions of dynamic disequilibrium. Since that time, the course of 
events has been shaped by mistakes and misunderstandings. The 
most tangible result is the disintegration of the Exchange Rate 
Mechanism which, in turn, is an important factor in the possible 
disintegration of the European Community. 
Let me start at the point where near-equilibrium conditions were 
replaced by a condition of dynamic disequilibrium. This point can

Appendix 371 
be fixed in time with great precision: it was the fall of the Berlin 
Wall. This opened the hay to German reunification. Chancellor 
Kohl rose to the historic occasion. He decided that reunification 
must be complete, immediate and achieved in a European context. 
Actually, he had no choice in the matter, since the German consti- 
tution gave East ~ermans citizenship of Germany and Germany 
was a member of the European Community. But it makes all the

difference whether youi take charge of events or merely react to 
them. Chancellor Kohl exhibited real leadership. He went to Presi- 
dent Mitterand and said to him, in effect, "I need your support and 
the support of Europe to achieve immediate and complete reunifi- 
cation." The French replied, in effect, "Let's create a stronger Eu- 
rope in which the reunified Germany can be fully embedded." This 
gave a tremendous impulse towards integration. It set into motion

the "boom" part of the boom/bust process. The British were op- 
posed to the creation of a strong central authority; you will recall 
Margaret Thatcher's speech at Bruges. Tough negotiations ensued, 
but there was a sense of urgency, a self-imposed deadline. The re- 
sult was the Treaty of ~aastricht, the two main goals of which were 
to establish a common currency and a common foreign policy. It 
had a number of other provisions, but they were less important

and, when the British objected, .they were allowed to opt out of 
some of them. All in all, the Treaty was a giant step forward to- 
wards integfation, a valiant attempt to create a Europe strong 
enough to cope with the revolutionary changes resu-ECting from the 
collapse of the Soviet empire. It went, perhaps, further and faster 
than public opinion was prepared for; but that was a chance that 
theleaders took in order to cope with the revolutionary situation.

r'iightly so, in my opinion, because that is what leadership entails. 
The trouble lay elsewhere. I shall not dwell on a side deal in 
which Germany got the agreement of the European Community to 
recognize Croatia and Slovenia as independent states. It was little 
discussed and little noticed at the time, but it had horrendous con- 
sequences. I want to focus on the internal disequilibrium in Ger- 
many which was generated by the reunification because it was that

disequilibrium which has turned the boom into a bust. 
The German government seriously underestimated the cost of 
reunification and was, in any case, unwilling to pay the full cost 
through higher taxation or a reduction of other government expen- 
ditures. This created tensions between the Bundesbank and the 
government on two levels: one was that the government acted

372 Appendix 
t against the express advice of the Bundesbank; the other was that a 
very loose fiscal policy-that is to say, a huge budget deficit- 
required a very tight monetary policy in order to reestablish mone- 
tary equilibrium. The injection of purchasing power through the 
exchange of East German currency at par created an inflationary 
boom, and the fiscal deficit added fuel to the fire. The Bundesbank 
was charged, by law, with the mission of maintaining the value of

the Deutschmark and it acted with alacrity. It raised the rep0 rate 
to 9.70 percent. But that policy was very harmful to the other mem- 
ber countries of the European Monetary System. In other words, 
the monetary policy which was designed to reestablish equilibrium 
at home created a disequilibrium within the European Monetary 
System. It took some time for the disequilibrium to develop but, 
I with the passage of time, the tight monetary policy imposed by the

Bundesbank pushed all of Europe into the deepest recession it has 
experienced since the Second World War. The Bundesbank plays a 
dual role: it is the guardian of sound money at home and it is the 
anchor of the EMS. It acted as the transmission mechanism for 
turning the internal disequilibrium of the German economy into a 
force for the disintegration of $he EMS. 
There was also a third and deeper level of conflict between the 
Bundesbank and the German government. Chancellor Kohl, in or-

der to obtain French support for German reunification, entered 
into the Treaty of Maastricht. That Treaty posed a profound threat 
to the institutional dominance, indeed, institutional survival, of 
the Bundesbank as the arbiter of European monetary policy. In 
the EMS, the German mark serves as the anchor. But, under the 
Maastricht Treaty, the role of the Bundesbank was to be replaced by 
a European central bank in which the Bundesbank v~~uld only have

one vote out of twelve. Admittedly, the European Central Bank was 
based on the German model; but it makes all the difference in the 
world whether you serve as the model or whether you are actually 
in charge. The Bundesbank never openly acknowledged that it was 
opposed to this institutional change, and it remains unclear to 
what extent its actions were designed to prevent it. All4 can tell 
you is that, as a market participant, I acted on the hypothesis that it

was the Bundesbank's underlying motivation. I cannot prove to you 
that my hypothesis was correct; all I can say is that it worked. 
For instance, I listened to Helmut Schlesinger warn that the mar- 
kets are mistaken when they think that the ECU consists of a fixed 
basket of currencies. I asked him what he thought of the ECU as the

Appendix 373 
future common currency of Europe. He said he would like it better 
if it were called the mark. 1 was guided accordingly. Shortly there- 
after, the lira was forced out of the ERM. 
1 don't want to get ,into a blow-by-blow account of what hap- 
pened because I want ,to establish a broad historical perspective. 
From that perspective,1 the salient features are that the Maastricht 
referendum was defeated in Denmark; it passed with a very nar-

row margin in France;'and it barely squeaked through Parliament 
in Britain. The European Exchange Rate Mechanism has, for all 
intents and purposes, broken down and it has done so in several 
installments, of which#the last one, namely, the broadening of the 
band in August, was the most far-reaching because it loosened the 
strongest tie within the European Community, the one which ties 
Germany and France together. What is in the long run even more

important, Europe is in the midst of a deep recession from which 
there is no immediate prospect of recovery. Unemployment is a se- 
rious and still-growing problem which continues to be aggravated 
by monetary policies which are far too restrictive for this stage of 
the cycle. From these observations, 1 conclude that the trend to- 
wards the integration of Europe has passed its peak and has now 
been reversed. 
The exact moment of reversal can be identified as the defeat in the

Danish referendum. It 'could have brought forth a groundswell of 
support >or the Maastricht Treaty; in that case, there would have 
been no reversal. Instead, it generated the breakhn of the Ex- 
change Rate Mechanism. Europe is now in a process of disintegra- 
tion. Since we are dealing with a boom/bust process, it is impossible 
to say how far it will go. But it may go much further than people are 
currently willing or able to envisage because a boomibust process is

self-reinforcing in both directions. 
1 can identify at least five elements which are mutually self- 
reinforcing. First and foremost is the recession; 11.7 percent un- 
employment in France, 14.1 percent in Belgium, and 22.25 percent 
in Spain, are simply not acceptable. They generate social and 
political unrest which is easily channeled in an anti-European di- 
rection. Second, there is the progressive disintegration of the Ex- 
change Rate Mechanism. This is very dangerous because in the

medium to long term the Common Market cannot survive with- 
out stability in exchange rates. 
The ERM functioned perfectly well in near-equilibrium condi- 
tions for more than a decade. But the reunification of Germany has

374 Appendix 
I revealed a fundamental flaw in the mechanism, namely, that the 
Bundesbank plays a dual role: guardian of domestic monetary sta- 
bility and anchor of the EMS. As long as the two roles are in har- 
mony, there is no problem. But when there was a conflict, the 
Bundesbank gave precedence to domestic considerations to the 
detriment of its international obligations. This was clearly demon- 
strated, for instance, on Thursday, July 29th, when it refused to

lower the discount rate in order to relieve the pressure on the 
French franc. It can be argued that the Bundesbank has no choice 
in the matter: it is obliged by law, the Grundgesetz, to give absolute 
priority to the preservation of the value of the German currency. 
In that case, there is an irreconcil251e cord lief between the ERM 
and the Grundgesetz. 
I This episode revealed another fundamental flaw in the ERM, 
namely, that there is an asymmetry between the obligations of the

anchor currency and the currency which is under pressure. All the 
obligations fall on the weak currency. It will be recalled that, at the 
time of the Bretton Woods agreement, John Maynard Keynes em- 
phasized the need for symmetry between the strong and the weak. 
He based his arguments on the experiences of the inter-war period. 
The current situation is increasingly reminiscent of that period and 
sometimes it seems as if Keynes had not lived.

sometimes it seems as if Keynes had not lived. 
This brings me to the third element, namely, mistaken economic 
and monetary policies. Here it is not so much the Bundesbank that 
is to blame but those who have opposed it, like the German govern- 
ment, or those who have been the victims of its policy, like the 
United Kingdom and France. The German government is, of 
course, responsible for creating the internal disequilibrium in the

first place. The British committed an egregious error in jviiiifig the 
Exchange Rate Mechanism on October Bth, 1990 after the reunifica- 
tion of Germany. They did so on the basis of arguments which had 
been developed in 1985, but were strenuously resisted by Margaret 
Thatcher. When her position weakened, she finally gave in, but by 
that time, the arguments which had been valid in 1985 were no 
longer applicable. So the British made two mistakes--o~_le in 1985 
and one in 1990.

and one in 1990. 
They were particularly hard hit by the high interest rate regime 
imposed on them by the Bundesbank because they were already in 
a recession when they went into the ERM. Being pushed out of the 
ERM brought them much-needed relief. They ought to have wel- 
comed it, but they were too dazed to react. They did the right thing

Appendix 375 
eventually and lowered interest rates, but they failed to seize the 
initiative. This has made it harder to build up confidence and it will 
make it much harder to reassert control over wages when the econ- 
omy does pick up. 
One would have thought the French would learn from the British 
experience. But they are proving even more inflexible. One could 
sympathize with their efforts to defend the franc fort policy because

they fought so long and so hard to establish it, and they were on the 
verge of reaping the benefits in the form of improved competitive- 
ness vis-a-vis Germany when the reward was snatched from their 
hands by recurrent attacks on the franc. But, once the franc fort pol- 
icy proved untenable, they ought Po have adjusted their approach to 
the new situation. Instead, they are sticking voluntarily with a 
regime which proved so disastrous when it was imposed on them

by the ERM. I think I understand their motivation: they are con- 
cerned with rebuilding their reserves and repaying the debt that 
the Banque de France incurred with the Bundesbank in defending 
the parity. But they got their priorities wrong. France is in a serious 
recession and it needs to lower interest rates. That is what brought 
on the August crisis. To try and keep the French franc close to the 
Deutschmark by keeping interest rates high is self-defeating. The

only way to have a strong franc is to have a strong economy. 
The Bundesbank itself has been remarkably consistent in the 
pursuit of its objectives, especially if we include institutional self- 
preservation among those objectives, and amazing% successful. It 
found itself in an impossible situation after the reunification of 
Germany: a sudden increase in the stock of money, an enormous 
budget deficit, and a threat to its institutional survival. Yet it came

out victorious. Whether it was worth the cost-a Europe-wide re- 
cession and the breakdown of the ERM-is another question. 
A few months ago I was convinced that the Bundesbank was fol- 
lowing the wrong monetary policy, even for domestic purposes, be- 
cause Germany was in a recession and monetary policy ought to be 
counter-cyclical. The Bundesbank stuck to its medium-term mone- 
tary targets, but I thought that M3-which had worked well as a

target in near-equilibrium conditions-had been rendered irrele- 
vant in today's far-from-equilibrium conditions; and I thought that 
the Bundesbank had overstayed its course in following a tight mon- 
etary policy. 
But that was before the widening of the bands in the ERM. Since 
then, the Deutschmark has rallied, the German long bonds have

376 Appendix 
I strengthened and, on top of it all, the German economy is showing 
some signs of strength. I must now admit that I may have been 
wrong and the Bundesbank may have been successful in its pursuit 
of its domestic policy goals. But, if anything, that strengthens my 
argument that there is a conflict of interest between the domestic 
responsibilities of the Bundesbank and its role as the anchor of the 
EMS. The events of the last two months have clearly demonstrated

that the needs of Germany and the rest of Europe are very differ- 
ent. Germany needs low interest rates on long bonds because it bor- 
rows at the long end, whereas the rest of Europe needs lower 
interest rates at the short end because the liquidity of the banking 
system needs to be rebuilt and hwer short-term rates zre needed to 
stimulate economic activity. Germany got what it needs, but the 
t rest of Europe did not. 
The fact that I may have been wrong on the Deutschmark brings

me to the fourth factor. It is not only the authorities who make mis- 
takes, but also market participants. Markets are often wrong. 
Specifically, they were wrong when 'they assumed that the path to a 
common currency would follow a straight line. International in- 
vestors, particularly managers of international bond funds, went for 
the highest yields, ignoring exchange rate risks. Helmut Schlesinger 
was right in warning that the ECU does not consist of a fixed basket

of currencies. There had been large capital movements into weak- 
currency countries like Italy, Spain and Portugal. The movement 
was initially self-reinforcing but eventually self-defeating. It cre- 
ated excessive rigidity in exchange rates in the first place, and exces- 
sive instability in the second. The errors of the market compounded 
the errors of the authorities in creating dynamic disequilibrium. 
Finally, there is a fifth factor that reinforces the trend toward

disintegration. It may be called the emotional amplifier. When 
things are going wrong, especially when mistakes are being made, 
there is an impulse to blame someone else. Who would have 
thought that respected officials like Jacques Delors and the Finance 
Minister of Belgium and the newly appointed head of the Banque 
de France really believed in an Anglo-Saxon conspiracy/ to destroy 
the Franco-German alliance? These attitudes then color subsequent

discussions as in the case of the GATT negotiations. 
There is also a sixth element which needs to be considered; 
namely, the instability of Eastern Europe and particularly of the 
former Yugoslavia. I believe that this factor is working in the oppo- 
site direction. The threat of instability and the influx of refugees

Appendix 377 
are good reasons to band together and build a "Fortress Europe." 
At the same time, tkie lack of unity in the European Community 
has the effect of reinforcing the political instability and economic 
decline in Eastern Europe. The outcome is going to be a European 
Community which is a far cry from the open society to which the 
people whom I suppdrt in Eastern Europe aspire. 
All this is truly disturbing and depressing. I realize that I sound

more like a prophet of gloom and doom than a guru. But let me re- 
mind you that there is nothing determinate about the boom/bust 
sequence; that the direction of the process can be reversed practi- 
cally at any time. Indeed, a reversal of direction is an essential part 
of a boom/bust sequence. What I am trying to say is that exrents are 
now going in the wrong direction and they will continue to go in 
that direction until we recognize that there is something funda-

mentally wrong and we take resolute action to correct it. 
There can be no doubt that there is something fundamentally 
wrong with the European Monetary System as it is currently con- 
stituted. First, the domestic obligations of the Bundesbank have 
proven to be irreconci'lable with its role as the anchor currency; in- 
deed, one could argue that the Bundesbank has exploited its role as 
the anchor currency in order to solve its domestic problems. Sec-

ond, there is an asymmetry between the obligations of the strong 
and the weak currencies. And most importantly, there is asymme- 
try between the risks and rewards of international investors, that is 
to say, speculators. These structural faults were these from the be- 
ginning, but they only became apparent in the course of the last 
year. Once they became known, it is impossible to return to the 
conditions which prevailed previously. The best way to eliminate

the faults of the ERM Is to have no exchange rate mechanism at 
all. But freely floating exchange rates would destroy the Common 
Market. Hence the necessity for a common currency. That means 
implementing the Maastricht Treaty. At the time the treaty was ne- 
gotiated, the path leading to the common currency was envisaged 
as a gradual, near-equilibrium path. But the gradual path has run 
into unexpected obstacles. To continue on a gradual path will now

lead in the opposite direction because there has been a trend rever- 
sal and we are now in a process of disintegration. Therefore we 
must find a different path. If we can't get there gradually, it is bet- 
ter to get there all at once than not to get there at all. 
At the emergency meeting on August lst, an official from 
Portugal reportedly proposed that the introduction of a common

378 Appendix 
1 currency should be speeded up. A German participant reportedly 
reacted by saying, "Surely, you must be joking!" If my line of ar- 
gument is correct, it is time to take the suggestion seriously. This 
may sound a little too facile, and it is. My argument will be taken 
seriously only if I can show a path that would lead to a common 
currency. Since we are in dynamic disequilibrium, the path has to 
be a disequilibrium one. At present, the first priority of the

Fre2ch monetary authorities is to rebuild their reserves. In order 
to do so, they are trying to keep the French franc strong. That is 
wrong. The first priority ought to be to stimulate the French econ- 
omy, and the maturity of the French debt to the Bundesbank 
ought to be extended for, say, two years so that France could low~r 
interest rates now. When I say lower interest rates, I mean three 
I percent. The rate reduction ought to be coordinated with the

other members of the EMS, excluding Germany and Holland. The 
Deutschmark would undoubtedly appreciate. The over valuation 
of the Deutschmark would have a negative effect on the German 
economy, hastening the decline in German interest rates. As the 
German economy weakened and the rest of Europe picked up, the 
trend in exchange rates would be reversed and they may eventu- 
ally settle down not very far from where they were before the

bands were widened. The main difference would be in economic 
activity. The rest of Europe would recover, first at the expense of 
Germany; but eventually Germany would also join the recovery. 
When that happened, the dynamic disequilibrium would have 
been corrected, and the march towards a common currency could 
be resumed in near-equilibrium conditions. The whole process 
would not take more than two years. After that, you could move

to a common currency directly, without reinstituting the narrow 
bands. But you cannot get there in a straight line. Right now, you 
are caught in a vicious circle; you need to turn it around and 
make it a virtuous circle. This has already happened, up to a 
point, in Italy. It could be done in the rest of Europe. 
I have not dealt with issues of foreign policy, the future of NATO 
and the fate of Eastern Europe, but I have covered too much ground

already. In any case, those issues are intricately interlinked with 
monetary policy. European monetary policy is wrong and it can be 
corrected.

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vi

data\The Basics of Finance An Introduction to Financial Markets, Business Finance, and Portfolio Management.pdf

The Basics of
Finance
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ii

Finance
An Introduction to Financial
Markets, Business Finance,
and Portfolio Management
PAMELA PETERSON DRAKE
FRANK J. FABOZZI
John Wiley & Sons, Inc.
iii

Copyright C⃝2010 by John Wiley & Sons. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
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Library of Congress Cataloging-in-Publication Data:
Fabozzi, Frank J.
The basics of ﬁnance : an introduction to ﬁnancial markets, business ﬁnance,
and portfolio management / Frank J. Fabozzi, Pamela Peterson Drake.
p. cm. – (Frank J. Fabozzi series ; 192)
Includes index.
ISBN 978-0-470-60971-2 (cloth); 978-0-470-87743-2 (ebk);978-0-470-87771-5 (ebk); 978-0-470-87772-2 (ebk)
1. Finance. I. Peterson Drake, Pamela, 1954- II. Title.
HG173.F25 2010332–dc22 2010010863

Printed in the United States of America.
1 0987654321
iv

To my husband, Randy, and my children, Ken and Erica
—P.P.D.
To my wife, Donna, and my children, Francesco,
Patricia, and Karly
—F.J.F.
v

Contents
Preface xiii
CHAPTER 1
What Is Finance? 1
Capital Markets and Capital Market Theory 3
Financial Management 4
Investment Management 6
Organization of This Book 7
The Bottom Line 8
Questions 8
PART ONE
The Financial System
CHAPTER 2
Financial Instruments, Markets, and Intermediaries 13
The Financial System 13
The Role of Financial Markets 17
The Role of Financial Intermediaries 18

Types of Financial Markets 24
The Bottom Line 33
Questions 33
CHAPTER 3
The Financial System’s Cast of Characters 37
Domestic Nonﬁnancial Sectors 39
Nonﬁnancial Businesses 42
Domestic Financial Sectors 43
Foreign Investors 60
The Bottom Line 60
Questions 61
vii

viii CONTENTS
PART TWO
Financial Management
CHAPTER 4
Financial Statements 65
Accounting Principles: What Are They? 66
The Basic Financial Statements 67
How Are the Statements Related? 81
Why Bother about the Footnotes? 82
Accounting Flexibility 83
U.S. Accounting vs. Outside of the U.S. 83
The Bottom Line 84
Solutions to Try It! Problems 85
Questions 86
CHAPTER 5
Business Finance 89

CHAPTER 5
Forms of Business Enterprise 90
The Objective of Financial Management 97
The Bottom Line 104
Solutions to Try It! Problems 105
Questions 105
CHAPTER 6
Financial Strategy and Financial Planning 109
Strategy and Value 110
The Budgeting Process 115
Budgeting 119
Performance Evaluation 120
Strategy and Value Creation 124
The Bottom Line 128
Questions 129
CHAPTER 7
Dividend and Dividend Policies 133
Dividends 134
Stock Distributions 137

Dividend Policies 141
Stock Repurchases 147
The Bottom Line 150
Solutions to Try It! Problems 151
Questions 151

Contents ix
CHAPTER 8
The Corporate Financing Decision 155
Debt vs. Equity 156
Financial Leverage and Risk 164
Financial Distress 168
The Cost of Capital 171
Optimal Capital Structure: Theory and Practice 175
The Bottom Line 180
Solutions to Try It! Problems 182
Questions 183
CHAPTER 9
Financial Risk Management 185
The Deﬁnition of Risk 185
Enterprise Risk Management 188
Managing Risks 193

The Bottom Line 197
Questions 198
PART THREE
Valuation and Analytical Tools
CHAPTER 10
The Math of Finance 201
Why the Time Value of Money? 201
Calculating the Future Value 203
Calculating a Present Value 213
Determining the Unknown Interest Rate 216
The Time Value of a Series of Cash Flows 217
Annuities 221
Loan Amortization 230
Interest Rates and Yields 232
The Bottom Line 238
Solutions to Try It! Problems 239
Questions 240
CHAPTER 11

CHAPTER 11
Financial Ratio Analysis 243
Classifying Financial Ratios 244
Liquidity 247

x CONTENTS
Proﬁtability Ratios 253
Activity Ratios 255
Financial Leverage 258
Return on Investment 262
The DuPont System 263
Common-Size Analysis 266
Using Financial Ratio Analysis 268
The Bottom Line 270
Solutions to Try It! Problems 270
Questions 271
CHAPTER 12
Cash Flow Analysis 275
Difﬁculties with Measuring Cash Flow 275
Free Cash Flow 283
Usefulness of Cash Flows Analysis 288

Ratio Analysis 290
The Bottom Line 292
Solutions to Try It! Problems 293
Questions 293
CHAPTER 13
Capital Budgeting 295
Investment Decisions and Owners’ Wealth 296
The Capital Budgeting Process 298
Determining Cash Flows from Investments 303
Capital Budgeting Techniques 321
The Bottom Line 344
Solutions to Try It! Problems 344
Questions 345
CHAPTER 14
Derivatives for Controlling Risk 349
Futures and Forward Contracts 350
Options 363
Swaps 376

Swaps 376
The Bottom Line 379
Appendix: Black-Scholes Option Pricing Model 380
Solutions to Try It! Problems 383
Questions 385

Contents xi
PART FOUR
Investment Management
CHAPTER 15
Investment Management 389
Setting Investment Objectives 391
Establishing an Investment Policy 393
Constructing and Monitoring a Portfolio 400
Measuring and Evaluating Performance 401
The Bottom Line 410
Solutions to Try It! Problems 411
Questions 412
CHAPTER 16
The Theory of Portfolio Selection 415
Some Basic Concepts 416

Estimating a Portfolio’s Expected Return 418
Measuring Portfolio Risk 421
Portfolio Diversiﬁcation 426
Choosing a Portfolio of Risky Assets 428
Issues in the Theory of Portfolio Selection 434
Behavioral Finance and Portfolio Theory 438
The Bottom Line 441
Solutions to Try It! Problems 442
Questions 443
CHAPTER 17
Asset Pricing Theory 445
Characteristics of an Asset Pricing Model 446
The Capital Asset Pricing Model 447
The Arbitrage Pricing Theory Model 461

Some Principles to Take Away 465
The Bottom Line 466
Solutions to Try It! Problems 467
Questions 467
CHAPTER 18
The Structure of Interest Rates 469
The Base Interest Rate 470
The Term Structure of Interest Rates 476
Term Structure of Interest Rates Theories 484

xii CONTENTS
Swap Rate Yield Curve 486
The Bottom Line 487
Solutions to Try It! problems 488
Questions 489
CHAPTER 19
Valuing Common Stock 491
Discounted Cash Flow Models 491
Relative Valuation Methods 503
The Bottom Line 509
Solutions to Try It! Problems 510
Questions 511
CHAPTER 20
Valuing Bonds 513
Valuing a Bond 514
Conventional Yield Measures 524

Valuing Bonds that Have Embedded Options 532
The Bottom Line 538
Solutions to Try It! Problems 539
Questions 540
Glossary 543
About the Authors 571
Index 573

Preface
An investment in knowledge pays the best interest.
—Benjamin Franklin
The purpose of this book is to provide an introduction to ﬁnancial decision-
making, and the framework in which these decisions are made. The Basics
of Finance is an accessible book for those who want to gain a better under-

standing of this ﬁeld, but lack a strong business background. In this book,we cover the essential concepts, tools, methods, and strategies in ﬁnance
without delving too far into theory.
InBasics of Finance , we discuss ﬁnancial instruments and markets, port-
folio management techniques, understanding and analyzing ﬁnancial state-ments, and corporate ﬁnancial strategy, planning, and policy. We explainconcepts in various areas of ﬁnance without getting too complicated.

We explore, in a basic way, topics such as cash ﬂow analysis, asset valu-
ation, capital budgeting, and derivatives. We also provide a solid foundationin the ﬁeld of ﬁnance, which you can quickly build upon.
Along the way, we provide sample problems—Try it! problems—so
that you can try out any math that we demonstrate in the chapter. Wealso provide end-of-chapter questions—with solutions easily accessible on
our web site—that test your knowledge of the basic terms and concepts

that we discuss in the chapter. Solutions to end-of-chapter problems can be
downloaded by visiting www.wiley.com/go/petersonbasics. Please log in to
the web site using this password: Petersonbasics123.
The Basics of Finance offers essential guidance on ﬁnancial markets and
institutions, business ﬁnance, portfolio management, risk management, andmuch more. If you’re looking to learn more about ﬁnance, this is the placeto start.
We thank Glen Larsen, Professor of Finance at the Kelley School of

Business, Indiana University, for coauthoring with us the section on relativevaluation in Chapter 19.
P
AMELA PETERSON DRAKE
May 2010
xiii

xiv

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CHAPTER1
What Is Finance?
A truly great business must have an enduring ‘moat’ that protects
excellent returns on invested capital. The dynamics of capitalism
guarantee that competitors will repeatedly assault any business
‘castle’ that is earning high returns. Therefore a formidable barriersuch as a company’s being the low cost producer (GEICO,

Costco) or possessing a powerful world-wide brand (Coca-Cola,
Gillette, American Express) is essential for sustained success.Business history is ﬁlled with ‘Roman Candles,’ companies whose
moats proved illusory and were soon crossed.
—Warren Buffett, Letter to Shareholders of Berkshire
Hathaway, February 2008
Finance is the application of economic principles to decision-making
that involves the allocation of money under conditions of uncertainty.

In other words, in ﬁnance we worry about money and we worry about
the future. Investors allocate their funds among ﬁnancial assets in or-
der to accomplish their objectives, and businesses and governments raise
funds by issuing claims against themselves and then use those funds foroperations.
Finance provides the framework for making decisions as to how to get

funds and what we should do with them once we have them. It is the ﬁnancialsystem that provides the platform by which funds are transferred from those
entities that have funds to those entities that need funds.
The foundations for ﬁnance draw from the ﬁeld of economics and, for
this reason, ﬁnance is often referred to as ﬁnancial economics . For example,
as you saw with the quote by Warren Buffett at the beginning of this chapter,

competition is important in the valuation of a company. The ability to keep
1

2 WHAT IS FINANCE?
Mathematics
Financial
accounting
EconomicsProbability
theory
Statistical
theory
PsychologyFinance
EXHIBIT 1.1 Finance and Its Relation to Other Fields
competitors at bay is valuable because it ensures that the company can
continue to earn economic proﬁts.1
FINANCE IS ...
■analytical, using statistical, probability, and mathematics to solveproblems.

■based on economic principles.
■uses accounting information as inputs to decision-making.
■global in perspective.
■the study of how to raise money and invest it productively.
The tools used in ﬁnancial decision-making, however, draw from many
areas outside of economics: ﬁnancial accounting, mathematics, probability
theory, statistical theory, and psychology, as we show in Exhibit 1.1.
We can think of the ﬁeld of ﬁnance as comprised of three areas: capital

markets and capital market theory, ﬁnancial management, and investment
1Economic proﬁts are earnings beyond the cost of capital used to generate those earn-
ings. In other words, economic proﬁts are those in excess of normal proﬁts—those
returns expected based on the investment’s risk.

What Is Finance? 3
Capital markets
and capital
market theory
Financial
managementInvestment
management
EXHIBIT 1.2 The Three Areas
within the Field of Finance
management, as we illustrate in Exhibit 1.2. And, as this exhibit illustrates,
the three areas are all intertwined, based on a common set of theories and

principles. In the balance of this chapter, we discuss each of these specialtyareas.
CAPITAL MARKETS AND CAPITAL MARKET THEORY
The ﬁeld of capital markets and capital market theory focuses on the study
of the ﬁnancial system, the structure of interest rates, and the pricing of risky
assets. The ﬁnancial system of an economy consists of three components:

(1) ﬁnancial markets; (2) ﬁnancial intermediaries; and (3) ﬁnancial regula-tors. For this reason, we often refer to this area as ﬁnancial markets and
institutions .
Several important topics included in this specialty area of ﬁnance are
the pricing efﬁciency of ﬁnancial markets, the role and investment behaviorof the players in ﬁnancial markets, the best way to design and regulateﬁnancial markets, the measurement of risk, and the theory of asset pricing.

The pricing efﬁciency of the ﬁnancial markets is critical because it deals
with whether investors can “beat the market.” If a market is highly price
efﬁcient , it is extremely difﬁcult for investors to earn returns that are greater
than those expected for the investment’s level of risk—that is, it is difﬁcultfor investors to beat the market. An investor who pursues an investmentstrategy that seeks to “beat the market” must believe that the sector of the

ﬁnancial market to which the strategy is applied is not highly price efﬁcient.
Such a strategy seeking to “beat the market” is called an active strategy .
Financial theory tells us that if a capital market is efﬁcient, the optimal

4 WHAT IS FINANCE?
strategy is not an active strategy, but rather is a passive strategy that seeks
to match the performance of the market.
In ﬁnance, beating the market means outperforming the market by gen-
erating a return on investment beyond what is expected after adjusting for

risk and transaction costs. To be able to quantitatively determine whatis “expected” from an investment after adjusting for risk, it is necessary
to formulate and empirically test theories about how assets are priced or,
equivalently, valuing an asset to determine its fair value.
A cow for her milkA hen for her eggs,
And a stock, by heck,
For her dividends.
An orchard for fruit,
Bees for their honey,
And stocks, besides,
For their dividends.
—John Burr Williams

“Evaluation of the Rule of Present Worth,”
Theory of Investment Value, 1937
The fundamental principle of valuation is that the value of any ﬁnancial
asset is the present value of the expected cash ﬂows. Thus, the valuation
of a ﬁnancial asset involves (1) estimating the expected cash ﬂows; (2) de-termining the appropriate interest rate or interest rates that should be used
to discount the cash ﬂows; and (3) calculating the present value of the ex-

pected cash ﬂows. For example, in valuing a stock, we often estimate future
dividends and gauge how uncertain are these dividends. We use basic math-
ematics of ﬁnance to compute the present value or discounted value of cashﬂows. In the process of this calculation of the present value or discounted
value, we must use a suitable interest rate, which we will refer to as a

discount rate. Capital market theory provides theories that guide investorsin selecting the appropriate interest rate or interest rates.
FINANCIAL MANAGEMENT
Financial management , sometimes called business ﬁnance orcorporate
ﬁnance, is the specialty area of ﬁnance concerned with ﬁnancial decision-making within a business entity. Although ﬁnancial management is often

What Is Finance? 5
referred to as corporate ﬁnance, the principles of ﬁnancial management
also apply to other forms of business and to government entities. Financialmanagers are primarily concerned with investment decisions and ﬁnancing
decisions within organizations, whether that organization is a sole propri-

etorship, a partnership, a limited liability company, a corporation, or agovernmental entity.
Regarding investment decisions, we are concerned with the use of
funds—the buying, holding, or selling of all types of assets: Should a busi-ness purchase a new machine? Should a business introduce a new product
line? Sell the old production facility? Acquire another business? Build a
manufacturing plant? Maintain a higher level of inventory?

Financing decisions are concerned with the procuring of funds that can
be used for long-term investing and ﬁnancing day-to-day operations. Shouldﬁnancial managers use proﬁts raised through the company’s revenues or
distribute those proﬁts to the owners? Should ﬁnancial managers seek money
from outside of the business? A company’s operations and investments canbe ﬁnanced from outside the business by incurring debt—such as through

bank loans or the sale of bonds—or by selling ownership interests. Because
each method of ﬁnancing obligates the business in different ways, ﬁnancingdecisions are extremely important. The ﬁnancing decision also involves the
dividend decision, which involves how much of a company’s proﬁt should
be retained and how much to distribute to owners.
A company’s ﬁnancial strategic plan is a framework of achieving its goal

of maximizing owner’s wealth. Implementing the strategic plan requires bothlong-term and short-term ﬁnancial planning that brings together forecasts ofthe company’s sales with ﬁnancing and investment decision-making. Budgets
are employed to manage the information used in this planning; performance
measures are used to evaluate progress toward the strategic goals.
Thecapital structure of a company is the mixture of debt and equity

that management elects to raise to ﬁnance the assets of the company. Thereare several economic theories about how the company should be ﬁnanced
and whether an optimal capital structure (that is, one that maximizes a
company’s value) exists.
Investment decisions made by the ﬁnancial manager involve the long-
term commitment of a company’s scarce resources in long-term investments.We refer to these decisions as capital budgeting decisions . These decisions

play a prominent role in determining the success of a business enterprise.
Although there are capital budgeting decisions that are routine and, hence,
do not alter the course or risk of a company, there are also strategic capitalbudgeting decisions that either affect a company’s future market position in
its current product lines or permit it to expand into new product lines in the
future.

6 WHAT IS FINANCE?
A ﬁnancial manager must also make decisions about a company’s cur-
rent assets. Current assets are those assets that could reasonably be con-
verted into cash within one operating cycle or one year, whichever takes
longer. Current assets include cash, marketable securities, accounts receiv-

able, and inventories, and support the long-term investment decisions of acompany.
Another critical task in ﬁnancial management is the risk management
of a company. The process of risk management involves determining whichrisks to accept, which to neutralize, and which to transfer. The four key
processes in risk management are risk:
1.Identiﬁcation
2.Assessment
3.Mitigation
4.Transference
The traditional process of risk management focuses on managing the

risks of only parts of the business (products, departments, or divisions),
ignoring the implications for the value of the company. Today, some form
ofenterprise risk management is followed by large corporations, which
is risk management applied to the company as a whole. Enterprise risk
management allows management to align the risk appetite and strategies
across the company, improve the quality of the company’s risk response

decisions, identify the risks across the company, and manage the risks across
the company.
The ﬁrst step in the risk management process is to acknowledge the
reality of risk. Denial is a common tactic that substitutes deliberate
ignorance for thoughtful planning.
—Charles Tremper
INVESTMENT MANAGEMENT
Investment management is the specialty area within ﬁnance dealing with the
management of individual or institutional funds. Other terms commonly

used to describe this area of ﬁnance are asset management ,portfolio man-
agement ,money management, andwealth management . In industry jargon,
an asset manager “runs money.”

What Is Finance? 7
Setting
investment
objectives
Establishing
an investment
policySelecting
specific assetsSelecting an
strategyMeasuring
and evaluating
performance
EXHIBIT 1.3 Investment Management Activities
Investment management involves ﬁve primary activities, as we detail in
Exhibit 1.3. Setting investment objectives starts with a thorough analysis

of what the entity or client wants to accomplish. Given the investmentobjectives, the investment manager develops policy guidelines, taking into
consideration any client-imposed investment constraints, legal/regulatory
constraints, and tax restrictions. This task begins with the decision of howto allocate assets in the portfolio (i.e., how the funds are to be allocated
among the major asset classes). The portfolio is simply the set of invest-

ments that are managed for the beneﬁt of the client or clients. Next, the
investment manager must select a portfolio strategy that is consistent with
the investment objectives and investment policy guidelines.
In general, portfolio strategies are classiﬁed as either active or passive.
Selecting the speciﬁc ﬁnancial assets to include in the portfolio, which is

referred to as the portfolio selection problem, is the next step. The theoryof portfolio selection was formulated by Harry Markowitz in 1952.
2This
theory proposes how investors can construct portfolios based on two param-eters: mean return and standard deviation of returns. The latter parameteris a measure of risk. An important task is the evaluation of the performance
of the asset manager. This task allows a client to determine answers to ques-

tions such as: How did the asset manager perform after adjusting for therisks associated with the active strategy employed? And, how did the asset
manager achieve the reported return?
ORGANIZATION OF THIS BOOK
We have organized this book in parts to enable you to see how allthe pieces in ﬁnance come together. In Part One, we provide the basic
2Harry M. Markowitz, “Portfolio Selection,” Journal of Finance 7(1952): 77–91.

8 WHAT IS FINANCE?
framework of the ﬁnancial system and the players in this system. In Part Two,
we focus on ﬁnancial management, and discuss ﬁnancial statements, ﬁnan-cial decision-making within a business enterprise, strategy, and decisions
including dividends, ﬁnancing, and investment management.
In Part Three, we focus more on the analytical part of ﬁnance, which

involves valuing assets, making investment decisions, and analyzing per-formance. In Part Four, we introduce you to investments, which include
derivatives and risk management, as well as portfolio management. In thispart, we also explain the basic methods that are used to value stocks and
bonds, and some of the theories behind these valuations.
THE BOTTOM LINE

■Finance blends together economics, psychology, accounting, statistics,mathematics, and probability theory to make decisions that involve
future outcomes.
■We often characterize ﬁnance as comprised of three related areas: capitalmarkets and capital market theory, ﬁnancial management, and invest-ment management.
■Capital markets and capital market theory focus on the ﬁnancial systemthat includes markets, intermediaries, and regulators.

■Financial management focuses on the decision-making of a business
enterprise, which includes decisions related to investing in long-lived
assets and ﬁnancing these investments.
■Investment management deals with managing the investments of indi-
viduals and institutions.
QUESTIONS
1.What distinguishes investment management from ﬁnancial manage-ment?
2.What is the role of a discount rate in decision-making?

3.What is the responsibility of the investment manager with respect to theinvestment portfolio?
4.Distinguish between capital budgeting and capital structure.
5.What are current assets?

What Is Finance? 9
6.If a market is price efﬁcient,
a.Can an investor “beat the market”?
b.Which type of portfolio management—active or passive—is best?
7.What does the ﬁnancing decision of a ﬁrm involve?
8.List the general steps in the risk management of a company.
9.What is enterprise risk management?
10.List the ﬁve activities of an investment manager.

10

c02 JWBT310-Fabozzi July 1, 2010 9:47 Printer: Courier Westford, Westford, MA
PARTOne
11

12

CHAPTER2
Financial Instruments, Markets,
and Intermediaries
A strong ﬁnancial system is vitally important—not for Wall Street,
not for bankers, but for working Americans. When our marketswork, people throughout our economy beneﬁt—Americans seeking
to buy a car or buy a home, families borrowing to pay for college,

innovators borrowing on the strength of a good idea for a newproduct or technology, and businesses ﬁnancing investments that
create new jobs. And when our ﬁnancial system is under stress,
millions of working Americans bear the consequences. Governmenthas a responsibility to make sure our ﬁnancial system is regulated
effectively. And in this area, we can do a better job. In sum,

the ultimate beneﬁciaries from improved ﬁnancial regulation areAmerica’s workers, families, and businesses—both large and small.
—Henry M. Paulson, Jr., then Secretary of the U.S. Department
of the Treasury, March 31, 2008
THE FINANCIAL SYSTEM
A country’s ﬁnancial system consists of entities that help facilitate the ﬂowof funds from those that have funds to invest to those who need funds toinvest. Consider if you had to ﬁnance a purchase of a home by rounding

up enough folks willing to lend to you. This would be challenging—and a
bit awkward. In addition, this would require careful planning—and lots ofpaperwork—to keep track of the loan contracts, and how much you must
repay and to whom. And what about the folks you borrow from? How are
they going to evaluate whether they should lend to you and what interest
rate they should charge you for the use of their funds?
13

14 THE FINANCIAL SYSTEM
In lending and investing situations, there is not only the awkwardness
of dealing directly with the other party or parties, but there is the problem
that one party has a different information set than the other. In other words,
there is information asymmetry.
A ﬁnancial system makes possible a more efﬁcient transfer of funds by

mitigating the information asymmetry problem between those with fundsto invest and those needing funds. In addition to the lenders and the bor-
rowers, the ﬁnancial system has three components: (1) ﬁnancial markets,where transactions take place; (2) ﬁnancial intermediaries, who facilitate
the transactions; and (3) regulators of ﬁnancial activities, who try to make

sure that everyone is playing fair. In this chapter, we look at each ofthese components and the motivation for their existence. Before we discuss
the participants, we need to ﬁrst discuss ﬁnancial assets, which represent the
borrowings or investments.
Financial Assets
Anasset is any resource that we expect to provide future beneﬁts and, hence,
has economic value. We can categorize assets into two types: tangible assets
andintangible assets. The value of a tangible asset depends on its physical

properties. Buildings, aircraft, land, and machinery are examples of tangibleassets, which we often refer to as ﬁxed assets.
An intangible asset represents a legal claim to some future economic
beneﬁt or beneﬁts. Examples of intangible assets include patents, copyrights,and trademarks. The value of an intangible asset bears no relation to the
form, physical or otherwise, in which the claims are recorded. Financial
assets, such as stocks and bonds, are also intangible assets because the future

beneﬁts come in the form of a claim to future cash ﬂows. Another term we
use for a ﬁnancial asset is ﬁnancial instrument. We often refer to certain
types of ﬁnancial instruments as securities, which include stocks and bonds.
For every ﬁnancial instrument, there is a minimum of two parties. The
party that has agreed to make future cash payments is the issuer; the party
that owns the ﬁnancial instrument and therefore the right to receive the
payments made by the issuer is the investor.

Why Do We Need Financial Assets?
Financial assets serve two principal functions:
1.They allow the transference of funds from those entities that have sur-
plus funds to invest to those who need funds to invest in tangible assets.

Financial Instruments, Markets, and Intermediaries 15
Entities
seeking funds
to invest in
tangible assetsFinancial
intermediaryEntities with
funds
available to
investFUNDS
FINANCIAL ASSETS
EXHIBIT 2.1 The Role of the Financial Intermediary
2.They permit the transference of funds in such a way as to redistribute the

unavoidable risk associated with the tangible assets’ cash ﬂow amongthose seeking and those providing the funds.
However, the claims held by the ﬁnal wealth holders generally dif-
fer from the liabilities issued by those entities because of the activity of
entities operating in ﬁnancial systems—the ﬁnancial intermediaries—who
transform the ﬁnal liabilities into different ﬁnancial assets preferred byinvestors (see Exhibit 2.1). We discuss ﬁnancial intermediaries in more
detail later.

What Is the Difference between Debt and Equity?
We can classify a ﬁnancial instrument by the type of claims that the investorhas on the issuer. A ﬁnancial instrument in which the issuer agrees to pay
the investor interest, plus repay the amount borrowed, is a debt instrument
or, simply, debt. A debt can be in the form of a note, bond, or loan. The

issuer must pay interest payments, which are ﬁxed contractually. In the caseof a debt instrument that is required to make payments in U.S. dollars,
the amount may be a ﬁxed dollar amount or percentage of the face value
of the debt, or it can vary depending upon some benchmark. The investorwho lends the funds and expects interest and the repayment of the debt is a
creditor of the issuer.
The key point is that the investor in a debt instrument can realize no

more than the contractual amount. For this reason, we often refer to debtinstruments as ﬁxed income instruments.

16 THE FINANCIAL SYSTEM
MICKEY MOUSE DEBT
The Walt Disney Company bonds issued in July 1993, which mature
in July 2093, pay interest at a rate of 7.55%. This means that Disney
pays the investors who bought the bonds $7.55 per year for every $100
of principal value of debt they own.
In contrast to a debt obligation, an equity instrument speciﬁes that the

issuer pay the investor an amount based on earnings, if any, after the obli-gations that the issuer is required to make to the company’s creditors arepaid. Common stock andpartnership shares are examples of equity instru-
ments. Common stock is the ownership interest in a corporation, whereas apartnership share is an ownership interest in a partnership. We refer to anydistribution of a company’s earnings as dividends.
AN EXAMPLE OF COMMON STOCK

At the end of 2008 there were 3,032,717 shares of common stockoutstanding of Proctor & Gamble, a U.S. consumer products company.
At that time, ﬁnancial institutions owned almost 60% of this stock.
These institutions include pension funds and mutual funds. Individual
investors owned the remainder of Proctor & Gamble’s stock.
The stock is listed on the New York Stock Exchange with the ticker
symbol PG.

symbol PG.
Some ﬁnancial instruments fall into both categories in terms of their
attributes. Preferred stock is such a hybrid because it looks like debt be-
cause investors in this security are only entitled to receive a ﬁxed contrac-tual amount. Yet preferred stock is similar to equity because the payment
to investors is only made after obligations to the company’s creditors aresatisﬁed.
Because preferred stockholders typically are entitled to a ﬁxed contrac-

tual amount, we refer to preferred stock as a ﬁxed income instrument. Hence,ﬁxed income instruments include debt instruments and preferred stock.
Another hybrid instrument is a convertible bond orconvertible note.
A convertible bond or note is a debt instrument that allows the investor to

Financial Instruments, Markets, and Intermediaries 17
convert it into shares of common stock under certain circumstances and at
a speciﬁed exchange ratio.
DO YOU WANT DEBT OR STOCK?
Sirius XM Radio (ticker: SIRI) issued convertible notes in October2004. These notes pay an interest rate of 3.25%, and can be exchanged
for the common stock of Sirius XM Radio Inc. at a rate of 188.6792

shares of the company’s common stock for every $1,000 principalamount of the notes.
The notes mature in 2011, so investors in these convertible notes
have until that time to exchange their note for shares; otherwise, theywill receive the $1,000 face value of the notes.
The classiﬁcation of debt and equity is important for two legal reasons.
First, in the case of a bankruptcy of the issuer, investors in debt instrumentshave a priority on the claim on the issuer’s assets over equity investors.

Second, in the United States, the tax treatment of the payments by the issuer
differs depending on the type of class. Speciﬁcally, interest payments made on
debt instruments are tax deductible to the issuer, whereas dividends are not.
THE ROLE OF FINANCIAL MARKETS
Investors exchange ﬁnancial instruments in a ﬁnancial market. The more
popular term used for the exchanging of ﬁnancial instruments is that they
are “traded.” Financial markets provide the following three major economic

functions: (1) price discovery, (2) liquidity, and (3) reduced transaction costs.
Price discovery means that the interactions of buyers and sellers in a
ﬁnancial market determine the price of the traded asset. Equivalently, theydetermine the required return that participants in a ﬁnancial market demand
in order to buy a ﬁnancial instrument. Financial markets signal how the

funds available from those who want to lend or invest funds are allocatedamong those needing funds. This is because the motive for those seeking
funds depends on the required return that investors demand.
Second, ﬁnancial markets provide a forum for investors to sell a ﬁnancial
instrument and therefore offer investors liquidity. Liquidity is the presence
of buyers and sellers ready to trade. This is an appealing feature when cir-

cumstances arise that either force or motivate an investor to sell a ﬁnancial

18 THE FINANCIAL SYSTEM
instrument. Without liquidity, an investor would be compelled to hold onto
a ﬁnancial instrument until either (1) conditions arise that allow for the dis-posal of the ﬁnancial instrument, or (2) the issuer is contractually obligated
to pay it off. For a debt instrument, that is when it matures, but for an eq-

uity instrument that does not mature—but rather, is a perpetual security—itis until the company is either voluntarily or involuntarily liquidated. All
ﬁnancial markets provide some form of liquidity. However, the degree of
liquidity is one of the factors that characterize different ﬁnancial markets.
The third economic function of a ﬁnancial market is that it reduces the

cost of transacting when parties want to trade a ﬁnancial instrument. Ingeneral, we can classify the costs associated with transacting into two types:search costs and information costs.
Search costs in turn fall into two categories: explicit costs and implicit
costs. Explicit costs include expenses to advertise one’s intention to sell or
purchase a ﬁnancial instrument. Implicit costs include the value of time
spent in locating a counterparty —that is, a buyer for a seller or a seller for a

buyer—to the transaction. The presence of some form of organized ﬁnancial
market reduces search costs.
Information costs are costs associated with assessing a ﬁnancial instru-
ment’s investment attributes. In a price-efﬁcient market, prices reﬂect theaggregate information collected by all market participants.
THE ROLE OF FINANCIAL INTERMEDIARIES
Despite the important role of ﬁnancial markets, their role in allowing the
efﬁcient allocation for those who have funds to invest and those who need

funds may not always work as described earlier. As a result, ﬁnancial sys-
tems have found the need for a special type of ﬁnancial entity, a ﬁnancial
intermediary, when there are conditions that make it difﬁcult for lenders or
investors of funds to deal directly with borrowers of funds in ﬁnancial mar-
kets. Financial intermediaries include depository institutions, nondepositﬁnance companies, regulated investment companies, investment banks, and
insurance companies.

The role of ﬁnancial intermediaries is to create more favorable transac-
tion terms than could be realized by lenders/investors and borrowers dealingdirectly with each other in the ﬁnancial market. Financial intermediaries ac-
complish this in a two-step process:
1.Obtaining funds from lenders or investors.
2.Lending or investing the funds that they borrow to those who needfunds.

Financial Instruments, Markets, and Intermediaries 19
The funds that a ﬁnancial intermediary acquires become, depend-
ing on the ﬁnancial claim, either the debt of the ﬁnancial intermediary
or equity participants of the ﬁnancial intermediary. The funds that a ﬁ-
nancial intermediary lends or invests become the asset of the ﬁnancial
intermediary.

Consider two examples using ﬁnancial intermediaries that we will elab-
orate upon further:
Example 1: A Commercial Bank
A commercial bank is a type of depository institution. Everyone knows
that a bank accepts deposits from individuals, corporations, and
governments. These depositors are the lenders to the commercial
bank. The funds received by the commercial bank become the lia-bility of the commercial bank. In turn, as explained later, a bank

lends these funds by either making loans or buying securities. The
loans and securities become the assets of the commercial bank.
Example 2: A Mutual Fund
A mutual fund is one type of regulated investment company. A mutual
fund accepts funds from investors who in exchange receive mutual
fund shares. In turn, the mutual fund invests those funds in a port-
folio of ﬁnancial instruments. The mutual fund shares representan equity interest in the portfolio of ﬁnancial instruments and the

ﬁnancial instruments are the assets of the mutual fund.
Basically, this process allows a ﬁnancial intermediary to transform ﬁ-
nancial assets that are less desirable for a large part of the investing public
into other ﬁnancial assets—their own liabilities—which are more widely
preferred by the public. This asset transformation provides at least one of
three economic functions:
1.Maturity intermediation.
2.Risk reduction via diversiﬁcation.

3.Cost reduction for contracting and information processing.
We describe each of these shortly.
There are other services that ﬁnancial intermediaries can provide. They
include:
■Facilitating the trading of ﬁnancial assets for the ﬁnancial intermediary’scustomers through brokering arrangements.

20 THE FINANCIAL SYSTEM
■Facilitating the trading of ﬁnancial assets by using its own capital to
take the other position in a ﬁnancial asset to accommodate a customer’stransaction.
■Assisting in the creation of ﬁnancial assets for its customers and theneither distributing those ﬁnancial assets to other market participants.
■Providing investment advice to customers.

■Managing the ﬁnancial assets of customers.
■Providing a payment mechanism.
We now discuss the three economic functions of ﬁnancial intermediaries
when they transform ﬁnancial assets.
Maturity Intermediation
In our example of the commercial bank, you should note two things. First,
the deposits’ maturity is typically short term. Banks hold deposits thatare payable upon demand or have a speciﬁc maturity date, and most are

less than three years. Second, the maturity of the loans made by a com-
mercial bank may be considerably longer than three years. Think aboutwhat would happen if commercial banks did not exist in a ﬁnancial sys-
tem. In this scenario, borrowers would have to either (1) borrow for a
shorter term in order to match the length of time lenders are willing to loanfunds; or (2) locate lenders that are willing to invest for the length of the
loan sought.

Now put commercial banks back into the ﬁnancial system. By issuing its
own ﬁnancial claims, the commercial bank, in essence, transforms a longer-term asset into a shorter-term one by giving the borrower a loan for the
length of time sought and the depositor—who is the lender—a ﬁnancialasset for the desired investment horizon. We refer to this function of a
ﬁnancial intermediary a maturity intermediation.
The implications of maturity intermediation for ﬁnancial systems are

twofold. The ﬁrst implication is that lenders/investors have more choices
with respect to the maturity for the ﬁnancial instruments in which theyinvest and borrowers have more alternatives for the length of their debt
obligations. The second implication is that because investors are reluctant
to commit funds for a long time, they require long-term borrowers to paya higher interest rate than on short-term borrowing. However, a ﬁnancial

intermediary is willing to make longer-term loans, and at a lower cost to the
borrower than an individual investor would because the ﬁnancial intermedi-ary can rely on successive funding sources over a long time period (although
at some risk). For example, a depository institution can reasonably expect
to have successive deposits to be able to fund a longer-term investment. As

Financial Instruments, Markets, and Intermediaries 21
a result of this intermediation, the cost of longer-term borrowing is likely
reduced in an economy.
Risk Reduction via Diversification
Consider the second example above of a mutual fund. Suppose that themutual fund invests the funds received from investors in the stock of a large

number of companies. By doing so, the mutual fund diversiﬁes and reduces
its risk. Diversiﬁcation is the reduction in risk from investing in assets whose
returns do not move in the same direction at the same time.
Investors with a small sum to invest would ﬁnd it difﬁcult to achieve
the same degree of diversiﬁcation as a mutual fund because of their lackof sufﬁcient funds to buy shares of a large number of companies. Yet by

investing in the mutual fund for the same dollar investment, investors can
achieve this diversiﬁcation, thereby reducing risk.
Financial intermediaries perform the economic function of diversiﬁca-
tion, transforming more risky assets into less risky ones. Though individualinvestors with sufﬁcient funds can achieve diversiﬁcation on their own, theymay not be able to accomplish it as cost effectively as ﬁnancial interme-
diaries. Realizing cost-effective diversiﬁcation in order to reduce risk by

purchasing the ﬁnancial assets of a ﬁnancial intermediary is an importanteconomic beneﬁt for ﬁnancial systems.
Reducing the Costs of Contracting and
Information Processing
Investors purchasing ﬁnancial assets must develop skills necessary to eval-
uate their risk and return. After developing the necessary skills, investorscan apply them in analyzing speciﬁc ﬁnancial assets when contemplating
their purchase or subsequent sale. Investors who want to make a loan to a

consumer or business need to have the skill to write a legally enforceable
contract with provisions to protect their interests. After investors make this
loan, they would have to monitor the ﬁnancial condition of the borrowerand, if necessary, pursue legal action if the borrower violates any provisions
of the loan agreement. Although some investors might enjoy devoting leisure

time to this task if they had the prerequisite skill set, most ﬁnd leisure timeto be in short supply and want compensation for sacriﬁcing it. The form of
compensation could be a higher return obtained from an investment.
In addition to the opportunity cost of the time to process the infor-
mation about the ﬁnancial asset and its issuer, we must consider the costof acquiring that information. Such costs are information-processing costs.

The costs associated with writing loan agreements are contracting costs.

22 THE FINANCIAL SYSTEM
Another aspect of contracting costs is the cost of enforcing the terms of the
loan agreement.
With these points in mind, consider our two examples of ﬁnancial

intermediaries—the commercial bank and the mutual fund. The staffs ofthese two ﬁnancial intermediaries include investment professionals trainedto analyze ﬁnancial assets and manage them. In the case of loan agreements,
either standardized contracts may be prepared, or legal counsel can be part
of the professional staff to write contracts involving transactions that aremore complex. Investment professionals monitor the activities of the bor-

rower to assure compliance with the loan agreement’s terms and, where
there is any violation, take action to protect the interests of the ﬁnancialintermediary.
It is clearly cost effective for ﬁnancial intermediaries to maintain such
staffs because investing funds is their normal business. There are economies
of scale that ﬁnancial intermediaries realize in contracting and processing
information about ﬁnancial assets because of the amount of funds that theymanage.

1These reduced costs, compared to what individual investors would
have to incur to provide funds to those who need them, accrue to the beneﬁtof (1) investors who purchase a ﬁnancial claim of the ﬁnancial intermediary;and (2) issuers of ﬁnancial assets (a result of lower funding costs).
Regulating Financial Activities

Most governments throughout the world regulate various aspects of ﬁnancialactivities because they recognize the vital role played by a country’s ﬁnancialsystem. Although the degree of regulation varies from country to country,
regulation takes one of four forms:
1.Disclosure regulation.
2.Financial activity regulation.
3.Regulation of ﬁnancial institutions.
4.Regulation of foreign participants.

Disclosure regulation requires that any publicly traded company provide
ﬁnancial information and nonﬁnancial information on a timely basis that
would be expected to affect the value of its security to actual and potentialinvestors. Governments justify disclosure regulation by pointing out that
1Economies of scale are the reduction of costs per unit when the number of units pro-

duced and sold increases. In this context, this is the cost advantage an intermediary
achieves when it increases the scale of its operations in contracting and processing.

Financial Instruments, Markets, and Intermediaries 23
the issuer has access to better information about the economic well-being
of the entity than those who own or are contemplating ownership of thesecurities.
Economists refer to this uneven access or uneven possession of informa-
tion as asymmetric information. In the United States, disclosure regulation

is embedded in various securities acts that delegate to the Securities and Ex-
change Commission (SEC) the responsibility for gathering and publicizing
relevant information, and for punishing those issuers who supply fraudu-lent or misleading data. However, disclosure regulation does not attempt
to prevent the issuance of risky assets. Rather, the SEC’s sole motivation

is to assure that issuers supply diligent and intelligent investors with theinformation needed for a fair evaluation of the securities.
Rules about traders of securities and trading on ﬁnancial markets com-
prise ﬁnancial activity regulation. Probably the best example of this type of
regulation is the set of rules prohibiting the trading of a security by those

who, because of their privileged position in a corporation, know more aboutthe issuer’s economic prospects than the general investing public. Such indi-
viduals are insiders and include, yet are not limited to, corporate managers
and members of the board of directors. Though it is not illegal for insid-ers to buy or sell the stock of a company in which they are considered an
insider, illegal insider trading is the trading in a security of a company by

a person who is an insider, and the trade is based on material, nonpublic
information. Illegal insider trading is another problem posed by asymmetric
information. The SEC is responsible for monitoring the trades that corporate
ofﬁcers, directors, as well as major stockholders, execute in the securities oftheir ﬁrms.
Another example of ﬁnancial activity regulation is the set of rules im-

posed by the SEC regarding the structure and operations of exchanges wheresecurities trade. The justiﬁcation for such rules is that it reduces the likeli-
hood that members of exchanges may be able, under certain circumstances,
to collude and defraud the general investing public. Both the SEC and the
self-regulatory organization, the Financial Industry Regulatory Authority
(FINRA), are responsible for the regulation of markets and securities ﬁrmsin the United States.

The SEC and the Commodity Futures Trading Commission (CFTC),
another federal government entity, share responsibility for the federal regula-tion of trading in options, futures and other derivative instruments. Deriva-
tive instruments are securities whose value depends on a speciﬁed other
security or asset. For example, a call option on a stock is a derivative secu-rity whose value depends on the value of the underlying stock; if the value

of the stock increases, the value of the call option on the stock increases
as well.

24 THE FINANCIAL SYSTEM
The regulation of ﬁnancial institutions is a form of governmental mon-
itoring that restricts their activities. Such regulation is justiﬁed by govern-
ments because of the vital role played by ﬁnancial institutions in a country’s
economy.
Government regulation of foreign participants involves the imposition

of restrictions on the roles that foreign ﬁrms can play in a country’s internalmarket and the ownership or control of ﬁnancial institutions. Although
many countries have this form of regulation, there has been a trend to lessenthese restrictions.
We list the major U.S. securities market and securities legislation in
Exhibit 2.2. The current U.S. regulatory system involves an array of industryand market-focused regulators.
Though the speciﬁcs of ﬁnancial regulatory reform are not determined

at the time of this writing, there are several elements of reform that appear
in the major proposals:
■An advanced-warning system, which would attempt to identify systemic
risks before they affect the general economy.
■Increased transparency in consumer ﬁnance, mortgage brokerage, asset-
baked securities, and complex securities.
■Increased transparency of credit-rating ﬁrms.
■Enhanced consumer protections.
■Increased regulation of nonbank lenders.

■Some measure to address the issue of ﬁnancial institutions that may beso large that their ﬁnancial distress affects the rest of the economy.
TYPES OF FINANCIAL MARKETS
Earlier we provided the general role of ﬁnancial markets in a ﬁnancial system.
In this section, we discuss the many ways to classify ﬁnancial markets.
From the perspective of a given country, we can break down a coun-

try’s ﬁnancial market into an internal market and an external market. Theinternal market , which we also refer to as the national market , is made up
of two parts: the domestic market and the foreign market. The domestic
market is where issuers domiciled in the country issue securities and where
investors then trade those securities. For example, from the perspective of
the United States, securities issued by Microsoft, a U.S. corporation, trade
in the domestic market.

Theforeign market is where securities of issuers not domiciled in the
country are sold and traded. For example, from a U.S. perspective, the

Financial Instruments, Markets, and Intermediaries 25
EXHIBIT 2.2 Federal Regulation of Securities Markets in the United States
Law Description
Securities Act of 1933 Regulates new offerings of securities to the
public. It requires the ﬁling of a registration
statement containing speciﬁc information
about the issuing corporation and prohibitsfraudulent and deceptive practices related to

security offers.
Securities and Exchange Act of
1934Establishes the Securities and Exchange
Commission (SEC) to enforce securities
regulations and extends regulation to thesecondary markets.
Investment Company Act of
1940Gives the SEC regulatory authority over
publicly held companies that are in thebusiness of investing and trading in securities.
Investment Advisers Act of
1940Requires registration of investment advisors
and regulates their activities.

Federal Securities Act of 1964 Extends the regulatory authority of the SEC to
include the over-the-counter securitiesmarkets.
Securities Investor Protection
Act of 1970Creates the Securities Investor Protection
Corporation, which is charged with theliquidation of securities ﬁrms that are inﬁnancial trouble and which insures investors’
accounts with brokerage ﬁrms.
Insider Trading Sanctions Act
of 1984Provides for treble damages to be assessed

against violators of securities laws.
Insider Trading and Securities
Fraud Enforcement Act of
1988Provides preventative measures against insider
trading and establishes enforcementprocedures and penalties for the violation of
securities laws.
Private Securities Litigation
Reform Act of 1995Limits shareholder lawsuits against companies,
provides safe-harbor for forward-lookingstatement by companies, and provides for

auditor disclosure of corporate fraud.
Securities Litigation Uniform
Standards Act of 1998Corrects the Private Securities Litigation
Reform Act of 1995, reducing the ability ofplaintiffs to bring securities fraud casesthrough state courts.
Sarbanes-Oxley Act of 2002 Wide-sweeping changes that provide reforms in
corporate responsibility and ﬁnancial
disclosures, creates the Public Company
Accounting Oversight Board, and increasedpenalties for accounting and corporate fraud.

26 THE FINANCIAL SYSTEM
securities issued by Toyota Motor Corporation trade in the foreign mar-
ket. We refer to the foreign market in the United States as the “Yankeemarket.”
The regulatory authorities where the security is issued impose the rules

governing the issuance of foreign securities. For example, non–U.S. corpora-tions that seek to issue securities in the United States must comply with U.S.
securities law. A non-Japanese corporation that wants to sell its securities
in Japan must comply with Japanese securities law and regulations imposedby the Japanese Ministry of Finance.
YANKEE MARKETS AND MORE ...

In Japan the foreign market is nicknamed the “Samurai market,” inthe United Kingdom the “Bulldog market,” in the Netherlands the“Rembrandt market,” and in Spain the “Matador market.”
The other sector of a country’s ﬁnancial market is the external market.
This is the market where securities with the following two distinguishingfeatures are trading:
1.At issuance the securities are offered simultaneously to investors in a
number of countries.

2.The securities are issued outside the jurisdiction of any single country.
We also refer to the external market as the international market ,t h e
offshore market , and the Euromarket (despite the fact that this market
is not limited to Europe).
The Money Market
Themoney market is the sector of the ﬁnancial market that includes ﬁnancial

instruments with a maturity or redemption date one year or less at the timeof issuance. Typically, money market instruments are debt instruments andinclude Treasury bills, commercial paper, negotiable certiﬁcates of deposit,
repurchase agreements, and bankers’ acceptances.
2
Treasury bills (popularly referred to as T-bills) are short-term securi-
ties issued by the U.S. government; they have original maturities of four

2Under certain circumstances, we consider preferred stock as a money market in-
strument.

Financial Instruments, Markets, and Intermediaries 27
weeks, three months, or six months. T-bills carry no stated interest rate.
Instead, the government sells these securities on a discounted basis. Thismeans that the holder of a T-bill realizes a return by buying these securities
for less than the maturity value and then receiving the maturity value at
maturity.

maturity.
Commercial paper is a promissory note—a written promise to
pay—issued by a large, creditworthy corporation or a municipality. Thisﬁnancial instrument has an original maturity that typically ranges from oneday to 270 days. The issuers of most commercial paper back up the paper
with bank lines of credit, which means that a bank is standing by ready to
pay the obligation if the issuer is unable to. Commercial paper may be eitherinterest bearing or sold on a discounted basis.

Certiﬁcates of deposit (CDs) are written promises by a bank to pay a
depositor. Investors can buy and sell negotiable certiﬁcates of deposit , which
are CDs issued by large commercial banks. Negotiable CDs typically haveoriginal maturities between one month and one year and have denominationsof $100,000 or more. Investors pay face value for negotiable CDs, and
receive a ﬁxed rate of interest on the CD. On the maturity date, the issuer
repays the principal, plus interest.

AEurodollar CD is a negotiable CD for a U.S. dollar deposit at a bank
located outside the United States or in U.S. International Banking Facilities.The interest rate on Eurodollar CDs is the London Interbank Offered Rate
(LIBOR), which is the rate at which major international banks are willing
to offer term Eurodollar deposits to each other.
Another form of short-term borrowing is the repurchase agreement. To

understand a repurchase agreement, we will brieﬂy describe why companiesuse this instrument. There are participants in the ﬁnancial system that use
leverage in implementing trading strategies in the bond market. That is, thestrategy involves buying bonds with borrowed funds. Rather than borrowing
from a bank, a market participant can use the bonds it has acquired as
collateral for a loan. Speciﬁcally, the lender will loan a certain amount of

funds to an entity in need of funds using the bonds as collateral. We refer to
this common lending agreement as a repurchase agreement or repo because
it speciﬁes that the borrower sells the bonds to the lender in exchange
for proceeds and at some speciﬁed future date the borrower repurchases
the bonds from the lender at a speciﬁed price. The speciﬁed price, calledthe repurchase price, is higher than the price at which the bonds are sold

because it embodies the interest cost that the lender is charging the borrower.
The interest rate in a repo is the repo rate. Thus, a repo is nothing more than
a collateralized loan; that is, a loan backed by a speciﬁc asset. We classify
it as a money market instrument because the term of a repo is typically less
than one year.

28 THE FINANCIAL SYSTEM
Bankers’ acceptances are short-term loans, usually to importers and ex-
porters, made by banks to ﬁnance speciﬁc transactions. An acceptance is
created when a draft (a promise to pay) is written by a bank’s customer andthe bank “accepts” it, promising to pay. The bank’s acceptance of the draft

is a promise to pay the face amount of the draft to whoever presents it for
payment. The bank’s customer then uses the draft to ﬁnance a transaction,giving this draft to the supplier in exchange for goods. Because acceptances
arise from speciﬁc transactions, they are available in a wide variety of prin-
cipal amounts. Typically, bankers’ acceptances have maturities of less than180 days. Bankers’ acceptances are sold at a discount from their face value,

and the face value is paid at maturity. The likelihood of default on bankers’
acceptances is very small because acceptances are backed by both the issuingbank and the purchaser of goods.
The Capital Market
Thecapital market is the sector of the ﬁnancial market where long-term
ﬁnancial instruments issued by corporations and governments trade. Here“long-term” refers to a ﬁnancial instrument with an original maturity greaterthan one year and perpetual securities (those with no maturity). There are

two types of capital market securities: those that represent shares of own-
ership interest, also called equity, issued by corporations, and those thatrepresent indebtedness, issued by corporations and by the U.S., state, and
local governments.
Earlier we described the distinction between equity and debt instru-
ments. Equity includes common stock and preferred stock. Because commonstock represents ownership of the corporation, and because the corporation

has a perpetual life, common stock is a perpetual security; it has no maturity.Preferred stock also represents ownership interest in a corporation and can
either have a redemption date or be perpetual.
A capital market debt obligation is a ﬁnancial instrument whereby the
borrower promises to repay the maturity value at a speciﬁed period of
time beyond one year. We can break down these debt obligations into twocategories: bank loans and debt securities. While at one time, bank loans

were not considered capital market instruments, today there is a market
for the trading of these debt obligations. One form of such a bank loan isasyndicated bank loan. This is a loan in which a group (or syndicate) of
banks provides funds to the borrower. The need for a group of banks arisesbecause the exposure in terms of the credit risk and the amount sought by aborrower may be too large for any one bank.
Debt securities include (1) bonds, (2) notes, (3) medium-term notes,

and (4) asset-backed securities. The distinction between a bond and a note

Financial Instruments, Markets, and Intermediaries 29
has to do with the number of years until the obligation matures when the
issuer originally issued the security. Historically, a note is a debt securitywith a maturity at issuance of 10 years or less; a bond is a debt security with
a maturity greater than 10 years.
The distinction between a note and a medium-term note has nothing

to do with the maturity, but rather the method of issuing the security.
3
Throughout most of this book, we refer to a bond, a note, or a medium-
term note as simply a bond. We will refer to the investors in any debtobligation as the debtholder ,bondholder, creditor,o rnoteholder .
The Derivative Market
We classify ﬁnancial markets in terms of cash markets and derivative mar-kets. The cash market ,a l s or e f e r r e dt oa st h e spot market , is the market for

the immediate purchase and sale of a ﬁnancial instrument. In contrast, some
ﬁnancial instruments are contracts that specify that the contract holder has
either the obligation or the choice to buy or sell something at or by somefuture date. The “something” that is the subject of the contract is the un-
derlying asset or simply the underlying. The underlying can be a stock, a

bond, a ﬁnancial index, an interest rate, a currency, or a commodity. Suchcontracts derive their value from the value of the underlying; hence, we refer
to these contracts as derivative instruments ,o rs i m p l yderivatives, and the
market in which they trade is the derivatives market.
Derivatives instruments, or simply derivatives, include futures, for-
wards, options, swaps, caps, and ﬂoors. We postpone a discussion of these

important ﬁnancial instruments, as well as their applications in corporateﬁnance and portfolio management, to later chapters.
The primary role of derivative instruments is to provide a transactionally
efﬁcient vehicle for protecting against various types of risk encountered by
investors and issuers. Admittedly, it is difﬁcult to see at this early stage

how derivatives are useful for controlling risk in an efﬁcient way since toooften the popular press focuses on how derivatives have been misused by
corporate treasurers and portfolio managers.
3This distinction between notes and bonds is not precisely true, but is consistent with
common usage of the terms note and bond. In fact, notes and bonds are distinguished

by whether or not there is an indenture agreement, a legal contract specifying theterms of the borrowing and any restrictions, and identifying a trustee to watch out
for the debtholders’ interests. A bond has an indenture agreement, whereas a note
does not.

30 THE FINANCIAL SYSTEM
The Primary Market
When an issuer ﬁrst issues a ﬁnancial instrument, it is sold in the primary
market. Companies sell new issues and thus raise new capital in this market.
Therefore, it is the market whose sales generate proceeds for the issuer of

the ﬁnancial instrument. Issuance of securities must comply with the U.S.securities laws. The primary market consists of both a public market and a
private placement market.
The public market offering of new issues typically involves the use of an
investment bank. The process of investment banks bringing these securitiesto the public markets is underwriting . Another method of offering new issues
is through an auction process. Bonds by certain entities such as municipal

governments and some regulated entities are issued in this way.
There are different regulatory requirements for securities issued to the
general investing public and those privately placed. The two major secu-rities laws in the United States—the Securities Act of 1933 and the Secu-
rities Exchange Act of 1934—require that unless otherwise exempted, allsecurities offered to the general public must register with the SEC.
One of the exemptions set forth in the 1933 Act is for “transactions by

an issuer not involving any public offering.” We refer to such offerings asprivate placement offerings. Prior to 1990, buyers of privately placed securi-
ties were not permitted to sell these securities for two years after acquisition.SEC Rule 144A, approved by the SEC in 1990, eliminates the two-yearholding period if certain conditions are met. As a result, the private place-
ment market is now classiﬁed into two categories: Rule 144A offerings and

non-Rule 144A (commonly referred to as traditional private placements).
The Secondary Market
Asecondary market is one in which ﬁnancial instruments are resold among
investors. Issuers do not raise new capital in the secondary market and,
therefore, the issuer of the security does not receive proceeds from the sale.
Trading takes place among investors. Investors who buy and sell securitieson the secondary markets may obtain the services of stockbrokers, entities

who buy or sell securities for their clients.
We categorize secondary markets based on the way in which they trade,
referred to as market structure. There are two overall market structures for
trading ﬁnancial instruments: order driven and quote driven.
Market structure is the mechanism by which buyers and sellers interact
to determine price and quantity. In an order-driven market structure , buyers
and sellers submit their bids through their broker, who relays these bids to

a centralized location for bid-matching, and transaction execution. We alsorefer to an order-driven market as an auction market.

Financial Instruments, Markets, and Intermediaries 31
In a quote-driven market structure, intermediaries (market makers or
dealers) quote the prices at which the public participants trade. Market
makers provide a bid quote (to buy) and an offer quote (to sell), and realize
revenues from the spread between these two quotes. Thus, market makers

derive a proﬁt from the spread and the turnover of their inventory of a
security. There are hybrid market structures that have elements of both aquote-driven and order-driven market structure.
We can also classify secondary markets in terms of organized ex-
changes and over-the-counter markets. Exchanges are central trading lo-
cations where ﬁnancial instruments trade. The ﬁnancial instruments must
be those listed by the organized exchange. By listed , we mean the ﬁnancial

instrument has been accepted for trading on the exchange. To be listed, the
issuer must satisfy requirements set forth by the exchange.
In the case of common stock, the major organized exchange is the New
York Stock Exchange (NYSE). For the common stock of a corporation tolist on the NYSE, for example, it must meet minimum requirements for
pretax earnings, net tangible assets, market capitalization, and number and
distribution of shares publicly held. In the United States, the SEC must

approve the market to qualify it as an exchange.
In contrast, an over-the-counter market (OTC market) is generally
where unlisted ﬁnancial instruments trade. For common stock, there arelisted and unlisted stocks. Although there are listed bonds, bonds are typ-
ically unlisted and therefore trade over-the-counter. The same is true ofloans. The foreign exchange market is an OTC market. There are listed and
unlisted derivative instruments.
Market Efficiency

Investors do not like risk and they must be compensated for taking onrisk—the larger the risk, the more the compensation. An important question
about ﬁnancial markets, which has implications for the different strategies
that investors can pursue, is this: Can investors earn a return on ﬁnancial
assets beyond that necessary to compensate them for the risk? Economistsrefer to this excess compensation as an abnormal return. In less technical

jargon, we referred to this in Chapter 1 as “beating the market.” Whetherthis can be done in a particular ﬁnancial market is an empirical question.If there is such a strategy that can generate abnormal returns, the attributes
that lead one to implement such a strategy is referred to as a market anomaly.
We refer to how efﬁciently a ﬁnancial market prices the assets traded
in that market as market efﬁciency. A price-efﬁcient market, or simply an

efﬁcient market , is a ﬁnancial market where asset prices rapidly reﬂect all
available information. This means that all available information is already
impounded into an asset’s price, so investors should expect to earn a return

32 THE FINANCIAL SYSTEM
necessary to compensate them for their anticipated risk. That would seem
to preclude abnormal returns. But, according to Eugene Fama, there arethe following three levels of market efﬁciency: (1) weak-form efﬁcient, (2)
semi-strong-form efﬁcient, and (3) strong-form efﬁcient.
4
In the weak form of market efﬁciency, current asset prices reﬂect all past

prices and price movements. In other words, all worthwhile informationabout historical prices of the stock is already reﬂected in today’s price; the
investor cannot use that same information to predict tomorrow’s price andstill earn abnormal proﬁts.
5
In the semi-strong form of market efﬁciency, the current asset prices
reﬂect all publicly available information. The implication is that if investorsemploy investment strategies based on the use of publicly available infor-

mation, they cannot earn abnormal proﬁts. This does not mean that prices
change instantaneously to reﬂect new information, but rather that asset
prices reﬂect this information rapidly. Empirical evidence supports the idea
that the U.S. stock market is for the most part semi-strong form efﬁcient.This, in turn, implies that careful analysis of companies that issue stocks
cannot consistently produce abnormal returns.
In the strong form of market efﬁciency , asset prices reﬂect all public

and private information. In other words, the market (which includes all in-vestors) knows everything about all ﬁnancial assets, including information
that has not been released to the public. The strong form implies that in-vestors cannot make abnormal returns from trading on inside information
(discussed earlier), information that has not yet been made public. In the

U.S. stock market, this form of market efﬁciency is not supported by empir-ical studies. In fact, we know from recent events that the opposite is true;
gains are available from trading on inside information. Thus, the U.S. stock
market, the empirical evidence suggests, is essentially semi-strong efﬁcientbut not in the strong form.
The implications for market efﬁciency for issuers is that if the ﬁnancial
markets in which they issue securities are semi-strong efﬁcient, issuers should

expect investors to pay a price for those shares that reﬂects their value. This
also means that if new information about the issuer is revealed to the public(for example, concerning a new product), the price of the security should
change to reﬂect that new information.
4Eugene F. Fama, “Efﬁcient Capital Markets: A Review of Theory and Empirical
Work ,” Journal of Finance 25 (1970): 383–417.
5Empirical evidence from the U.S. stock market suggests that in this market there is

weak-form efﬁcient. In other words, you cannot outperform (“beat”) the market by
using information on past stock prices.

Financial Instruments, Markets, and Intermediaries 33
■Financial intermediaries serve the ﬁnancial system by facilitating the
ﬂow of funds from entities with funds to invest to entities seeking funds.
■Financial markets provide price discovery, provide liquidity, and reducetransactions costs in the ﬁnancial system.

■Financial intermediaries not only facilitate the ﬂow of funds in the ﬁ-
nancial system, but they also transform ﬁnancial claims, providing more
choices for both investors and borrowers, reducing risk through diver-siﬁcation, and reducing costs.
■Regulation of ﬁnancial markets takes one of four forms: disclosure reg-ulation, ﬁnancial activity regulation, regulation of ﬁnancial institutions,and regulation of foreign participants.

■Financial markets can be classiﬁed as follows: money markets ver-sus capital markets, cash versus derivatives markets, primary versus
secondary markets, and market structure (order driven versus quote
driven).
■Market price efﬁciency falls into three categories (weak form, semi-
strong form, and strong form), and the form of this efﬁciency determines
whether investors can consistently earn abnormal proﬁts.
QUESTIONS
1.What distinguishes indebtedness and equity?

2.Is preferred stock a debt or equity instrument? Explain.
3.How does a mutual fund perform its function as a ﬁnancialintermediary?
4.What is meant by the term “maturity intermediation”?
5.In the United States, who are the regulators of ﬁnancial markets?
6.What are examples of money market securities? Provide at least fourexamples.
7.What is the difference between an exchange and an over-the-counter
market?

market?
8.What are the three forms of market efﬁciency?
9.What distinguishes a primary market from a secondary market?
10.What distinguishes a spot market from a derivatives market?
11.What distinguishes the money market from the capital market?
12.How does the efﬁciency of a market affect an investor’s strategy?
13.The following is an excerpt taken from a January 11, 2008, speech
entitled “Monetary Policy Flexibility, Risk Management, and Financial

34 THE FINANCIAL SYSTEM
Disruptions” by Federal Reserve Governor Frederic S. Mishkin (www.
federalreserve.gov/newsevents/speech/mishkin20080111a.htm):
Although ﬁnancial markets and institutions deal with large vol-umes of information, some of this information is by nature
asymmetric. ...Historically, banks and other ﬁnancial interme-

diaries have played a major role in reducing the asymmetry of
information, partly because these ﬁrms tend to have long-term
relationships with their clients.
The continuity of this information ﬂow is crucial to the
process of price discovery. ...During periods of ﬁnancial dis-
tress, however, information ﬂows may be disrupted and price
discovery may be impaired. As a result, such episodes tend togenerate greater uncertainty.
Answer the following questions pertaining to the statement:

a.What is meant by asymmetric “information by nature”?
b.What is the problem caused by information asymmetry in ﬁnancial
markets?
c.How do you think banks have historically “played a major role inreducing the asymmetry of information”?
d.What is meant by “price discovery”?
e.Why is the continuity of information ﬂow critical to the process ofprice discovery?

14.The following is an excerpt taken from a November 30, 2007,speech entitled “Innovation, Information, and Regulation in FinancialMarkets” by Federal Reserve Governor Randall S. Kroszner (www.
federalreserve.gov/newsevents/speech/kroszner20071130a.htm):
Innovations in ﬁnancial markets have created a wide range of
investment opportunities that allow capital to be allocated toits most productive uses and risks to be dispersed across a wide

range of market participants. Yet, as we are now seeing, in-
novation can also create challenges if market participants facedifﬁculties in valuing a new instrument because they realize that
they do not have the information they need or if they are un-
certain about the information they do have. In such situations,price discovery and liquidity in the market for those innovative
products can become impaired.

Financial Instruments, Markets, and Intermediaries 35
Answer the questions pertaining to the statement:
a.What are the information costs associated with ﬁnancial assets?
b.What is meant by “liquidity”?
c.Why do you think that for innovative ﬁnancial products price dis-covery and liquidity could become impaired?
15.The following is an excerpt taken from a November 30, 2007,

speech entitled “Innovation, Information, and Regulation in Financial
Markets” by Federal Reserve Governor Randall S. Kroszner (www.federalreserve.gov/newsevents/speech/kroszner20071130a.htm):
Another consequence of information investments is a tendencytowards greater standardization of many of the aspects of an
instrument, which can help to increase transparency and re-
duce complexity. ...Standardization in the terms and in the

contractual rights and obligations of purchasers and sellers ofthe product reduces the need for market participants to engagein extensive efforts to obtain information and reduces the need
to verify the information that is provided in the market through
due diligence. Reduced information costs in turn lower trans-action costs, thereby facilitating price discovery and enhancing
market liquidity. Also, standardization can reduce legal risks

because litigation over contract terms can result in case lawthat applies to similar situations, thus reducing uncertainty.
Answer the following questions pertaining to the statement:a.What does Governor Kroszner mean when he says standardization
“reduces the need for market participants to engage in extensive
efforts to obtain information and reduces the need to verify theinformation that is provided in the market through due diligence”?

b.How do “Reduced information costs in turn lower transaction costs,thereby facilitating price discovery and enhancing market liquidity”?

36

c03 JWBT310-Fabozzi July 8, 2010 13:3 Printer: Courier Westford, Westford, MA
CHAPTER3
The Financial System’s
Cast of Characters
Financial crises are extremely difﬁcult to anticipate, and each
episode of ﬁnancial instability seems to have unique aspects, buttwo conditions are common to most such events. First, major
crises usually involve ﬁnancial institutions or markets that are

either very large or play some critical role in the ﬁnancial system.Second, the origins of most ﬁnancial crises (excluding, perhaps,
those attributable to natural disasters, war, and other nonﬁnancial
events) can be traced to failures of due diligence or “marketdiscipline” by an important group of market participants.
—Ben Bernanke, Chairman of the Federal Reserve System,
March 6, 2007

There is a large number of players in the ﬁnancial system who buy and sellﬁnancial instruments. The Federal Reserve (“the Fed”), in information
about the ﬁnancial markets that it publishes quarterly, classiﬁes players intosectors. We report the broadest classiﬁcation in Exhibit 3.1. The purpose ofthis chapter is to introduce you to all these players in the ﬁnancial system,
which we will do using the Federal Reserve’s classiﬁcation by sectors.

Households and nonproﬁts are self explanatory, so we will focus on the
other sectors.
Another way to look at the ﬁnancial system is by considering how much
each sector contributes to the gross domestic product (GDP). Consider the
GDP components for 2008 for the United States, as we show in Exhibit 3.2.
As you can see, nonﬁnancial businesses contribute the most to GDP.
As we discussed in Chapter 2, however, the ﬁnancial sectors facilitate

the ﬂow of funds in the economy. Therefore, this sector does not produce as
37

38 THE FINANCIAL SYSTEM
U.S. Economy
Domestic
nonfinancial
sectorsForeign sector
Government
sectorDepository
institutions
Nondepository
finance
institutionsNonfinancial
businesses
Households &
nonprofitsInsurance
companies
Investment
companiesDomestic
finance sectors
EXHIBIT 3.1 A Map of the U.S. Financial System
EXHIBIT 3.2 U.S. Gross Domestic Product, 2008

Data source: U.S. Census Bureau, The 2010 Statistical
Abstract, www.census.gov.

The Financial System’s Cast of Characters 39
much GDP as the nonﬁnancial businesses, the ﬁnancial sectors are important
in the ﬁnancing and investing activities of nonﬁnancial businesses.
DOMESTIC NONFINANCIAL SECTORS
The Government Sector
The government sector includes the federal government, as well as state and
local government:
sector
Government-
owned

sector
owned
corporationsGovernment-
sponsored
enterprisesState and local
governmentFederal
government
Also included in the government sectors are government–owned and
government-sponsored enterprises.
The Federal Government The U.S. federal government raises funds by
issuance of securities. The securities, referred to as Treasury securities ,
are issued by the U.S. Department of the Treasury through an auction
process.

process.
We show the amount of U.S. government debt over time and who owns
this debt in Exhibit 3.3. Up until the most recent ﬁnancial crisis, the majorowners were Federal Reserve Banks and foreign investors; the latter include
foreign governments. In the last few quarters in Exhibit 3.3, you see the
accumulation of government debt by depository institutions.
Government-Owned Corporations The federal government has agencies

that participate in the ﬁnancial market by buying and selling securities. The
federal government has chartered entities to provide funding for speciﬁc U.S.
government projects. These entities are called government-owned corpora-
tions. A good example is the Tennessee Valley Authority (TVA), which was
established by Congress in 1933 primarily to provide ﬂood control, nav-

igation, and agricultural and industrial development, and to promote theuse of electric power in the Tennessee Valley region. Two other examples
of government-owned corporations are the United States Postal Service and
the National Railroad Passenger Corporation (more popularly known as

40 THE FINANCIAL SYSTEM
$4,000$6,000$8,000$10,000$12,000$14,000$16,000$18,000$20,000In billionsOther
Foreign and international 
investors
Mutual funds 
Insurance companies
Pension funds
U.S. savings bonds
Depository institutions    
$0$2,000
2000 June
2001 June
2002 June
2003 June
2004 June
2005 June
2006 June
2007 June
2008 June
2009 JunePrivately held
Federal reserve and

intragovernmentalholdings State and local governments
EXHIBIT 3.3 U.S. Government Debt, 2000Q2–2009Q2 (in billions)
Data source: U.S. Department of the Treasury.
Amtrak). In fact, of all the government-owned corporations, the TVA is the
only one that is a frequent issuer of securities directly into the ﬁnancial mar-kets. Other government-owned corporations raise funds through the Federal

Financing Bank (FFB). The FFB is authorized to purchase or sell obligations
issued, sold, or guaranteed by other federal agencies.
Government-Sponsored Enterprises Another type of government-
chartered entity is one that is chartered to provide support for two sectors
that are viewed as critically important to the U.S. economy: housing and
agricultural sectors. These entities are government-sponsored enterprises
(GSEs), and are privately owned entities.
1We provide a listing of GSEs in

Exhibit 3.4.
There are two types of GSEs. The ﬁrst is a publicly owned shareholder
corporation whose stock is publicly traded. The publicly owned GSEs in-
clude the Federal National Mortgage Association, Federal Home Loan
Mortgage Corporation, and Federal Agricultural Mortgage Corporation.The ﬁrst two are the most well known GSEs because of the key role that
they played in the housing ﬁnance market. Both Fannie Mae and Freddie

Mac have similar purposes, which are to promote home ownership through
1In other countries, the term state-owned corporation is used.

The Financial System’s Cast of Characters 41
EXHIBIT 3.4 U.S. GSEs
Name Nickname Type Purpose
Federal Agricultural
Mortgage CorporateFAMC or
Farmer MacPublicly owned Agricultural
Federal Farm Credit System FFCS Funding entity Agricultural
Federal Home Loan Banks FHLB Funding entity Housing
Federal Home Loan
Mortgage CorporationFHLMC or
Freddie MacPublicly owned Housing

Federal National Mortgage
CorporationFNMA or
Fannie MaePublicly owned Housing
the availability of ﬁnancing. They accomplish this by buying mortgages,
pooling them, and selling mortgaged-backed securities to investors. Because
of the ﬁnancial difﬁculties faced by both Fannie Mae and Freddie Mac,
the U.S. government took control of these two GSEs by placing them intoconservatorship.
2
The other type of GSE is a funding entity of a federally chartered bank

lending system and includes the Federal Home Loan Banks and the FederalFarm Credit Banks.
Government-sponsored corporations are often confused with
government-owned corporations. An important distinction is that govern-ment owned corporations do not issue stock to the public, whereas GSEs
issue stock. Another distinction is that government-owned corporations are

not operated for a proﬁt, whereas GSEs are proﬁt-oriented. Still anotherdistinction is that the entire board of directors of a government-owned
corporation is appointed by the U.S. President, whereas only ﬁve of nine
directors are appointed by the President for GSEs such as Fannie Mae and
Freddie Mac.
3
State and Local Governments State and local governments are both issuers
and investors in the ﬁnancial markets. In addition, these entities establish

authorities and commissions that issue securities in the ﬁnancial market.Examples include the New York/New Jersey Port Authority.
2The Federal Housing Finance Agency (FHFA) is the conservator of both Fannie
Mae and Freddie Mac, which means that the FHFA has full power over the assets
and operations of these ﬁrms.
3This is, of course, not considering the currently conservatorship, which gives the
federal government more power in GSEs than typical.

42 THE FINANCIAL SYSTEM
State and local governments invest when they have excess cash due to
the mismatch between the timing of tax or other revenues and when those
funds have to be spent. However, the major reason why they participate
as investors is due to the funds available to invest from the pension funds

that they sponsor for their employees. More speciﬁcally, many state andlocal governments provide a deﬁned beneﬁt program, a form of pension
where they guarantee beneﬁts to the employees and their beneﬁciaries. The
ﬁve largest state and local sponsors of deﬁned pension funds (referred to aspublic pension funds) and their size, in billions of total assets as of January
26, 2009, according to Pension & Investments are:
California Public Employees $213.5
California State Teachers $147.0

New York State Common $138.4
Florida State Board $114.5
New York City Retirement $ 93.2
NONFINANCIAL BUSINESSES
Nonﬁnancial businesses are enterprises formed by individuals and other
businesses to engage in activities for a proﬁt, where these activities are not
primarily those of a ﬁnancial intermediary, such as a commercial bank.These businesses issue debt and equity instruments, and they invest in
ﬁnancial markets.

Businesses participate as investors in the ﬁnancial market by investing
excess funds in the money market and, as with state and local governments,invest the funds of the deﬁned beneﬁt plans in which they sponsor. The
largest deﬁned beneﬁt pension funds of businesses in the United States are
those of nonﬁnancial corporations. According to Pensions & Investments ,
the ﬁve largest as of January 26, 2009, in terms of total asset (in billions) are:
General Motors $91.0AT&T $61.9

General Electric $50.0
IBM $49.4
Boeing $42.5
Some nonﬁnancial businesses have subsidiaries that are involved in the
same activities as ﬁnancial corporations. The ﬁnancial subsidiaries, which
we refer to as captive ﬁnance companies , participate in the ﬁnancial market
by lending funds. Examples include Ford Motor Credit (a subsidiary of Ford

The Financial System’s Cast of Characters 43
Motor) and General Electric Credit Corporation (a subsidiary of General
Electric).
DOMESTIC FINANCIAL SECTORS
The ﬁnancial sectors include enterprises that and regulators that providethe framework for facilitating lending and borrowing. We can classify these
enterprises into different sectors, depending on the type of transactions they

facilitate:
Domestic
financial sector
Depository
financial
institutionsNondepository
financial
institutionsInsuranceInvestment
companies
Depository Institutions
Depository institutions include commercial banks and thrifts. Thrifts include
savings and loan associations, savings banks, and credit unions. As the nameindicates, these entities accept deposits that represent the liabilities (i.e., debt)
of the deposit-accepting institution. With the funds raised through deposits

and nondeposit sources obtained by issuing debt obligations in the ﬁnancialmarket, depository institutions make loans to various entities (businesses,
consumers, and state and local governments).
Commercial banks are the largest type of depository institution and
will be the focus here. A commercial bank is a ﬁnancial institution that isowned by shareholders, and engages in accepting deposits and lending for a

proﬁt. A bank may be owned by a bank holding company (BHC), which isa company that owns one or more banks.
The ﬁve largest bank holding companies in the United States as of
September 30, 2009, and their total assets in billions according to the FederalReserve System, National Information Center are:
Bank of America $2,253
J.P. Morgan Chase & Company $2,041Citigroup $1,889
Wells Fargo & Company $1,229
Goldman Sachs Group $ 883

44 THE FINANCIAL SYSTEM
Bank Services The principal services provided by commercial banks are:
1.Individual banking
2.Institutional banking
3.Global banking
Individual banking includes consumer lending, residential mortgage
lending, consumer installment loans, credit card ﬁnancing, automobile and
boat ﬁnancing, brokerage services, student loans, and individual-oriented

ﬁnancial investment services such as personal trust and investment services.
Institutional banking includes loans to both nonﬁnancial and ﬁnancial
business, government entities (state and local governments in the UnitedStates and foreign governments), commercial real estate ﬁnancing, and leas-ing activities.
In global banking, commercial banks compete head-to-head with an-
other type of ﬁnancial institution—investment banking companies.
4In the

4In the
global arena, banks engage in corporate ﬁnancing that involves (1) procur-
ing of funds for a bank’s customers, which can go beyond traditional bank
loans to involve the underwriting of securities and providing letters of credit
and other types of guarantees; and (2) ﬁnancial advice on such matters
as strategies for obtaining funds, corporate restructuring, divestitures, andacquisitions. Capital market and foreign exchange products and services in-

volve transactions where the bank may act as a dealer or broker in a service.
Bank Funding Banks are highly leveraged ﬁnancial institutions, meaning
that most of their funds come from borrowing.
5One form of borrowing
includes deposits. There are four types of deposit accounts issued by banks:
demand deposits, savings deposits, time deposits, and money market demand
accounts. Demand deposits , more popularly known as checking accounts,

can be withdrawn upon demand and offer minimal interest. Savings deposits
pay interest (typically below market interest rates), do not have a speciﬁcmaturity, and usually can be withdrawn upon demand. Time deposits ,m o r e
4We discuss investment banking later, which covers a broad range of activities in-
volving corporate ﬁnancing and capital market and foreign exchange products and
services.
5At one time, some of these activities were restricted by the Banking Act of 1933,

which contained four sections (popularly referred to as the Glass-Steagall Act) bar-
ring commercial banks from certain investment banking activities. The restrictionswere effectively repealed with the enactment of the Gramm-Leach-Bliley Act in
November 1999, which expanded the permissible activities for banks and bank
holding companies.

The Financial System’s Cast of Characters 45
popularly referred to as certiﬁcates of deposit or CDs, have a ﬁxed maturity
date and pay either a ﬁxed or ﬂoating interest rate. A money market demand
account pays interest based on short-term interest rates.
Deposit sources other than borrowing that are available to banks are (1)

borrowing by the issuance of instruments in the money and bond markets;(2) borrowing reserves in the federal funds market; and (3) borrowing from
the Federal Reserve (Fed) through the discount window facility. The ﬁrst
source is self-explanatory. The last two require explanation.
A bank cannot invest $1 for every $1 it raises via deposit because it

must maintain a speciﬁed percentage of its deposits in a noninterest-bearingaccount at one of the 12 Federal Reserve Banks. These speciﬁed percentagesare the reserve ratios, and the dollar amounts based on them that are required
to be kept on deposit at a Federal Reserve Bank are called required reserves.
The reserve ratios are established by the Federal Reserve Board and

represent one of the monetary policy tools employed by the Fed. Banks sat-isfy these reserve requirements in each period by actual reserves , which are
deﬁned as the average amount of reserves held at the close of business at
the Federal Reserve Bank. If actual reserves exceed required reserves, the
difference is referred to as excess reserves. Because reserves are placed in
noninterest-bearing accounts, an opportunity cost is associated with excess

reserves. However, if there is shortfall, the Fed imposes penalties. Conse-
quently, there is an incentive for banks to manage their reserves so as tosatisfy reserve requirements as precisely as possible. There is a market where
banks that are temporarily short of their required reserves can borrow re-
serves from banks with excess reserves. This market is called the federal
funds market, and the interest rate charge to borrow funds in this market is
called the federal funds rate .

Now let’s look at how a bank can borrow at the Fed discount window.
The Fed discount window is charged with the lending to banks to meet
liquidity needs, with the Federal Reserve Bank effectively being the banker’sbank. This means that the Federal Reserve Bank is the bank of last resort.
If a bank is temporarily short of funds, it can borrow from the Fed at its

discount window. However, borrowing at the discount window requiresthat the bank seeking funds put up collateral to do so. That is, the Fed is
willing to make a secured or collateralized loan. The Fed establishes (and
periodically changes) the types of collateral that are eligible for borrowingat the discount window. The interest rate that the Fed charges to borrow
funds at the discount window is called the discount rate . The Fed changes

this rate periodically in order to implement monetary policy.
Bank Regulation Because of their important role in ﬁnancial markets, de-
pository institutions are highly regulated and supervised by several federal

46 THE FINANCIAL SYSTEM
and state government entities. At the federal level, supervision is undertaken
by the Federal Reserve Board, the Ofﬁce of the Comptroller of the Currency,and the Federal Deposit Insurance Corporation (FDIC). Banks are insured
by the Bank Insurance Fund (BIF), which is administered by the Federal

Deposit Insurance Corporation. Federal depository insurance began in the1930s, and the insurance program is administered by the FDIC.
As already noted, the capital structure of banks is a highly leveraged
one. That is, the ratio of equity capital to total assets is low, typically lessthan 8%. Consequently, there are concerns by regulators about potential
insolvency resulting from the low level of capital provided by the owners.

An additional concern is that the amount of equity capital is even lessadequate because of potential liabilities that do not appear on the bank’s
balance sheet, so-called “off-balance sheet” obligations such as letters of
credit and obligations on OTC derivatives. This is addressed by regulators
via risk-based capital requirements.
The international organization that has established guidelines for risk-

based capital requirements is the Basel Committee on Banking Supervision(“Basel Committee”). This committee is made up of banking supervisory
authorities from 13 countries. By “risk-based,” it is meant that the capitalrequirements of a bank depend on the various risks to which it is exposed.
Nondepository Financial Institutions
Nondepository ﬁnancial institutions are intermediaries that do not acceptdeposits, but lend funds to consumers and businesses.
6Examples of these

institutions include consumer loan companies, trust companies, mortgage
loan companies, credit counseling agencies, and ﬁnance companies.
Unlike depository institutions, nondepository ﬁnancial institutions have
been regulated only at the state level in the U.S., but there is a current
discussion on increased regulation of these institutions on the national level,especially in the case of failures of large nondepository ﬁnancial institutions.
7

7
One such failure was that of CIT Group, Inc., a commercial and consumerﬁnance company, which ﬁled for bankruptcy in 2009.
6Nondepository ﬁnancial institutions are also referred to as nonbank ﬁnancial insti-
tutions (NBFIs). The distinction of these types of companies as ﬁnancial institutions
was made starting with the Annuzio-Wylie Anti-Money Laundering Act of 1992,
which broadened the deﬁnition of a ﬁnancial institution beyond deposit accepting
institutions.

7Chairman Ben S. Bernanke, “Financial Reform to Address Systemic Risk,” March
10, 2009.

The Financial System’s Cast of Characters 47
Insurance Companies
Insurance companies play an important role in an economy in that they are
risk bearers or the underwriters of risk for a wide range of insurable events.
Moreover, beyond their risk bearer role, insurance companies are major
participants in the ﬁnancial market as investors.

To understand why, we will explain the basic economics of the insur-
ance industry. As compensation for insurance companies selling protectionagainst the occurrence of future events, they receive one or more pay-ments over the life of the policy. The payment that they receive is called a
premium. Between the time that the premium is made by the policyholder

to the insurance company and a claim on the insurance company is paid out(if such a claim is made), the insurance company can invest those proceeds
in the ﬁnancial market.
The insurance products sold by insurance companies include:
■Life insurance. Policies insure against death with the insurance company
paying the beneﬁciary of the policy in the event of the death of the

insured. Life policies can be for pure life insurance coverage (e.g., termlife insurance) or can have an investment component (e.g., cash value
life insurance).
■Health insurance. The risk insured is the cost of medical treatment for
the insured.
■Property and casualty insurance. The risk insured against ﬁnancial lossresulting from the damage, destruction, or loss to property of the insuredproperty attributable to an identiﬁable event that is sudden, unexpected,

or unusual. The major types of such insurance are (1) a residential
property house and its contents and (2) automobiles.
■Liability insurance. The risk insured against is litigation, the risk of
lawsuits against the insured resulting from the actions by the insured or
others.
■Disability insurance . This product insures against the inability of an em-
ployed person to earn an income in either the insured’s own occupationor any occupation.

■Long-term care insurance . This product provides long-term coverage
for custodial care for those no longer able to care for themselves.
■Structured settlements . These policies provide for ﬁxed guaranteed pe-
riodic payments over a long period of time, typically resulting from asettlement on a disability or other type of policy.
■Investment-oriented products . The products have a major investment
component. They include a guaranteed investment contract (GIC) and

annuities . In the case of a GIC, a life insurance company agrees that

48 THE FINANCIAL SYSTEM
upon the payment of a single premium, it will repay that premium plus
a predetermined interest rate earned on that premium over the life ofthe policy.
8While there are many forms of annuities, they all have two

fundamental features: (1) whether the periodic payments begin imme-diately or are deferred to some future date and (2) whether the dollaramount is ﬁxed (i.e., guaranteed dollar amount) or variable depending
on the investment performance realized by the insurer.
■Financial guarantee insurance . The risk insured by this product is the
credit risk that the issuer of an insured bond or other ﬁnancial contractwill fail to make timely payment of interest and principal. A bond or

other ﬁnancial obligation that has such a guarantee is said to have aninsurance “wrap.” At one time, a large percentage of bonds issued by
municipal governments were insured bonds, as well as asset-backed
securities.
The leading insurance companies globally, in terms of 2008 revenues,
are:
9
Company Country Type of Insurance
Japan Post Holdings Japan Life/health
Allianz Germany Property/casualty
Berkshire Hathaway United States Property/casualty
Assicurazioni Generali Italy Life/health

AXA France Life/health
In the United States, the leading companies include Berkshire Hathaway,State Farm Insurance, and MetLife.
Investment Companies
Investment companies, also known as asset management companies , manage
the funds of individuals, businesses, and state and local governments, andare compensated for this service by fees that they charge. The fee is tiedto the amount that is managed for the client and, in some cases, to the

performance of the assets managed. Some asset management companies
8Basically, a GIC is insuring that the policyholder will receive a guaranteed interest
rate rather than risk that interest rates decline over the life of the policy. In the case
of an annuity, the policyholder pays a single premium for the policy and the lifeinsurance company agrees to make periodic payments over time to the policyholder.
9The source of this information is the Insurance Information Institute.

The Financial System’s Cast of Characters 49
are subsidiaries of commercial banks, insurance companies, and investment
banking companies.
The types of accounts, clients, and lines of business of asset management
companies include:
■Regulated investment companies
■Exchange-traded funds
■Hedge funds
■Separately managed accounts
■Pension funds

Regulated Investment Companies Regulated investment companies (RICs)
are ﬁnancial intermediaries that sell shares to the public and invest those
proceeds in a diversiﬁed portfolio of securities. Asset management companies
are retained to manage the portfolio of RICs. Various U.S. securities lawsregulate these entities.
There are three types of RICs managed by asset management companies:

open-end funds, closed-end funds, and unit investment trusts (UITs). As youcan see in Exhibit 3.5, mutual funds are the predominant form of RIC.
EXHIBIT 3.5
Assets of Regulated Investment Companies, 1995–2009 (billions)
Net Assets, in Billions of Dollars
Year Mutual Funds Closed-End Funds Unit Investment Trusts
1995 $ 2,811 $143 $73
1996 3,526 147 72
1997 4,468 152 85
1998 5,525 156 94
1999 6,846 147 92
2000 6,965 143 74
2001 6,975 141 49
2002 6,390 159 36
2003 7,414 214 36
2004 8,107 254 37

2005 8,905 277 41
2006 10,397 298 50
2007 12,000 313 53
2008 9,601 188 29
2009 11,121 228 38
Data source: Investment Company Institute.

50 THE FINANCIAL SYSTEM
Each share sold represents a proportional interest in the portfolio of
securities managed by the RIC on behalf of its shareholders. Additionally,
the value of each share of the portfolio (not necessarily the price) is called
thenet asset value (NAV) and is computed as follows:
NAV =Market value of portfolio −Liabilities
Number of shares

For example, suppose that a RIC with 20 million shares outstanding has
a portfolio with a market value of $430 million and liabilities of $30 million.The NAV is
NAV =$430, 000,000−$30,000,000
20,000,000=$20
The NAV is determined only at the close of the trading day.
Mutual Funds Inopen-end funds , commonly referred to simply as mutual
funds , the number of fund shares is not ﬁxed. All new investments into

the fund are purchased at the NAV and all redemptions (sale of the fund)redeemed from the fund are purchased at the NAV. The total number of
shares in the fund increases if more investments than withdrawals are madeduring the day, and vice versa.
For example, assume that at the beginning of a day a mutual fund port-
folio is valued at $300 million, with no liabilities, and 10 million sharesoutstanding. Thus, the NAV of the fund is $30. Assume that during the

trading day investors deposit $5 million into the fund and withdraw $2 mil-
lion, and the prices of all the securities in the portfolio remain constant. The$3 million net investment into the fund means that 100,000 shares were
issued ($3 million divided by $30). After the transaction, there are 10.1
million shares and the market value of the portfolio is $303 million. Hence,
the NAV is $30, unchanged from the prior day.
If, instead, the portfolio’s value and the number of shares change, the

NAV will change. However, at the end of day, NAV will be the same regard-less of the net shares added or redeemed. In the previous example, assume
that at the end of the day the portfolio’s value increases to $320 million. Be-cause new investments and withdrawals are priced at the end-of-day NAV,
which is now $32, the $5 million of new investments will be credited with
$5 million ÷$32=156,250 shares and the $2 million redeemed will reduce

the number of shares by $2 million ÷$32=62,500 shares. Thus, at the
end of the day the fund has 10 million +156,250 −62,500= 10,093,750
shares. Because the portfolio has a total value of $323 million ($320 million

The Financial System’s Cast of Characters 51
plus the new investment of $3 million), the end-of-day NAV is $32 and not
impacted by the transactions.
Closed-End Funds Unlike open-end funds, closed-end funds do not issue
additional shares or redeem shares. That is, the number of fund shares is
ﬁxed at the number sold at issuance (i.e., at the time of the initial public

offering). Instead, investors who want to sell their shares or investors whowant to buy shares must do so in the secondary market where the shares are
traded (either on an exchange or in the over-the-counter market).
Supply and demand in the market in which funds are traded deter-
mine the price of the shares of a closed-end fund. Hence, the fund share’sprice can trade below or above the NAV. Shares selling below NAV are

said to be “trading at a discount,” while shares trading above NAV are“trading at a premium.” Investors who transact in closed-end fund shares
must pay a brokerage commission at the time of purchase and at the time
of sale.
Unit Investment Trusts There is a third type of RIC called a unit investment
trust (UIT). This type of RIC is assembled, but not actively managed. A unit

investment trust has a ﬁnite life and a ﬁxed portfolio of investments.Costs to Investors Investors in RICs bear two types of costs: (1) a share-
holder fee, usually called the sales charge, which is a “one-time” charge;
and (2) an annual fund operating expense, usually called the expense ratio ,
which covers the fund’s expenses. The largest expense component of theexpense ratio is the management fee (also called the investment advisory

fees), which is an annual fee paid to the asset management company for its
services.
RICs are available with different investment objectives and investing
in different asset classes—stock funds, bond funds, and money marketfunds. There are passively managed and actively managed funds. Passive
funds (more commonly referred to as index funds ) are designed to repli-

cate a market index, such as the S&P 500 stock index in the case ofcommon stock. In contrast, with active funds the fund advisor attempts
to outperform an index and other funds by actively trading the fund
portfolio.
Exchange-Traded Funds As an investment vehicle, open-end funds (i.e.,
mutual funds) are often criticized for two reasons. First, their shares are
priced at, and can be transacted only at, the end-of-the-day or closing

price. Speciﬁcally, transactions (i.e., purchases and sales) cannot be made
at intraday prices, but only at closing prices. Second, while we did not

52 THE FINANCIAL SYSTEM
$700
$600
$0$100$200$300$400$500
Year1995
1996
1997
1998
1999
2000
2001
20022003
2004
2005
2006
2007
2008
EXHIBIT 3.6 Growth of ETF Assets, 1995–2008 (billions)
discuss the tax treatment of open-end funds, we note that they are inefﬁ-
cient tax vehicles. This is because withdrawals by some fund shareholders

may cause taxable realized capital gains for shareholders who maintain their
positions.
As a result of these two drawbacks of mutual funds, in 1993, a new
investment vehicle with many of the same features of mutual funds wasintroduced into the U.S. ﬁnancial market— exchange-traded funds (ETFs).
This investment vehicle is similar to mutual funds but trades like stocks on
an exchange. Even though they are open-end funds, ETFs are, in a sense,

similar to closed-end funds, which have small premiums or discounts fromtheir NAV. In an ETF, the investment advisor assumes responsibility for
maintaining the portfolio such that it replicates the index and the index’s
return accurately. Because supply and demand determine the secondary mar-ket price of these shares, the exchange price may deviate slightly from the
value of the portfolio and, as a result, may provide some imprecision in

pricing. Deviations remain small, however, because arbitrageurs can create
or redeem large blocks of shares on any day at NAV, signiﬁcantly limiting
the deviations.
Another advantage of ETFs in addition to being able to transact in
ETFs at current prices throughout the day is the ﬂexibility to place limitorders, stop orders, and orders to short sell and buy on margin, none ofwhich can be done with open-end funds. With respect to taxation, ETFs

overcome the disadvantages of open-end funds but we will not discuss the
advantages here.
From 1995, up until 2008, there has been a steady growth in ETFs, as
we show in Exhibit 3.6. There are ETFs that invest in a broad range of assetclasses and new ones being introduced weekly.

The Financial System’s Cast of Characters 53
Hedge Funds The U.S. securities law does not provide a deﬁnition of the
pools of investment funds run by asset managers that are referred to as hedge
funds .10These entities as of this writing are not regulated.
The following is a deﬁnition of hedge funds offered by the United King-

dom’s Financial Services Authority, the regulatory body of all providers of
ﬁnancial services in that country:11
The term can also be deﬁned by considering the characteristics most
commonly associated with hedge funds. Usually, hedge funds:
■Are organised as private investment partnerships or offshore in-
vestment corporations.
■Use a wide variety of trading strategies involving position-takingin a range of markets.
■Employ an assortment of trading techniques and instruments,

often including short-selling, derivatives, and leverage.
■Pay performance fees to their managers.
■Have an investor base comprising wealthy individuals and insti-tutions and a relatively high minimum investment limit (set at
US$100,000 or higher for most funds).
This deﬁnition helps us to understand several attributes of hedge funds.
First and foremost, the word “hedge” in hedge funds is misleading because it
is not a characteristic of hedge funds today. Second, hedge funds use a wide

range of trading strategies and techniques in an attempt to not just generateabnormal returns but rather attempt to generate stellar returns regardless of
how the market moves. The strategies used by a hedge fund can include one
or more of the following:
■Leverage, which is the use of borrowed funds
■Short selling, which is the sale of a ﬁnancial instrument not owned inanticipation of a decline in that ﬁnancial instrument’s price
■Derivatives to great leverage and control risk

■Simultaneous buying and selling of related ﬁnancial instruments to re-alize a proﬁt from the temporary misalignment of their prices
10The term hedge fund was ﬁrst used by Fortune in 1966 to describe the private
investment fund of Alfred Winslow Jones. In managing the portfolio, Jones sought
to “hedge” the market risk of the fund by creating a portfolio that was long andshort the stock market by an equal amount.

54 THE FINANCIAL SYSTEM
Hedge funds operate in sectors of the ﬁnancial markets: cash market for
stocks, bonds, and currencies, as well as in derivatives markets.
Third, in evaluating hedge funds, investors are interested in the absolute
return generated by the asset manager, not the relative return. Absolute
return is simply the return realized rather than relative return, which is the

difference between the realized return and the return on some benchmark
or index, which is quite different from the criterion used when evaluating
the performance of an asset manager.
Fourth, the management fee structure for hedge funds is a combination
of a ﬁxed fee based on the market value of assets managed plus a share ofthe positive return. The latter is a performance-based compensation referredto as an incentive fee.
In the United States, hedge funds are available to accredited investors.

As deﬁned by the SEC, accredited investors include individuals with a net
worth over $1 million, banks, insurance companies, and registered invest-
ment companies.
12
Separately Managed Accounts Instead of investing directly in stocks or
bonds, or by means of alternatives such as mutual funds, ETFs, or hedgefunds, asset management companies offer individual and institutional in-
vestors the opportunity to invest in a separately managed account (also

called an individually managed account ). In such accounts, the investments
selected by the asset manager are customized to the objectives of the in-vestor. Although separately managed accounts offer the customers of an
asset management an investment vehicle that overcomes all the limitationsof RICs, they are more expensive than RICs in terms of the fees charged.
Pension Funds A pension plan fund is established for the eventual pay-

ment of retirement beneﬁts. A plan sponsor is the entity that establishes the
pension plan. A plan sponsor can be:
■A private business entity on behalf of its employees, called a corporate
plan orprivate plan.
■A federal, state, and local government on behalf of its employees, called
apublic plan.
■A union on behalf of its members, called a Taft-Hartley plan .
■An individual, called an individually sponsored plan.
12Deﬁned in Securities and Exchange Commission Rule 501 of Regulation D.

The Financial System’s Cast of Characters 55
Two basic and widely used types of pension plans are deﬁned beneﬁt
plans and deﬁned contribution plans. In addition, a hybrid type of plan,
called a cash balance plan, combines features of both pension plan types.
In adeﬁned beneﬁt (DB) plan, the plan sponsor agrees to make speciﬁed

dollar payments to qualifying employees beginning at retirement (and somepayments to beneﬁciaries in case of death before retirement). Effectively, the
DB plan pension obligations are a debt obligation of the plan sponsor and
consequently the plan sponsor assumes the risk of having insufﬁcient fundsin the plan to satisfy the regular contractual payments that must be made to
currently retired employees as well as those who will retire in the future.

A plan sponsor has several options available in deciding who should
manage the plan’s assets. The choices are:
■Internal management. The plan sponsor uses its own investment staff
to manage the plan’s assets.
■External management. The plan sponsor engages the services of one or
more asset management companies to manage the plan’s assets.
■Combination of internal and external management. Some of the plan’s

assets are managed internally by the plan sponsor and the balance aremanaged by one or more asset management companies.
Asset managers who manage the assets of deﬁned beneﬁt plans receive
compensation in the form of a management fee.
There is federal legislation that regulates pension plans—the Employee
Retirement Income Security Act of 1974 (ERISA). Responsibility for admin-
istering ERISA is delegated to the Department of Labor and the Internal

Revenue Service. ERISA established ﬁduciary standards for pension fund
trustees, managers, or advisors.
In a deﬁned contribution (DC) plan, the plan sponsor is responsible
only for making speciﬁed contributions into the plan on behalf of qualifyingparticipants with the amount that it must contribute often being either a
percentage of the employee’s salary and/or a percentage of the employer’s

proﬁts. The plan sponsor does not guarantee any speciﬁc amount at retire-ment. The amount that the employee receives at retirement is not guaranteed,
but instead depends on the growth (therefore, performance) of the plan as-
sets. The plan sponsor does offer the plan participants various options asto the investment vehicles in which they may invest. Deﬁned contribution
pension plans come in several legal forms: 401(k) plans, money purchase

pension plans, and employee stock ownership plans (ESOPs).
A hybrid pension plan is a combination of a deﬁned beneﬁt and de-
ﬁned contribution plan with the most common type being a cash balanceplan. This plan deﬁnes future pension beneﬁts, not employer contributions.

56 THE FINANCIAL SYSTEM
Retirement beneﬁts are based on a ﬁxed amount annual employer contri-
bution and a guaranteed minimum annual investment return. Each partic-ipant’s account in a cash balance plan is credited with a dollar amount
that resembles an employer contribution and is generally determined as a

percentage of pay. Each participant’s account is also credited with interestlinked to some ﬁxed or variable index such as the consumer price index
(CPI). Typically, a cash balance plan provides beneﬁts in the form of a lump
sum distribution such as an annuity.
Investment Banks
As with commercial banks, investment banks are highly leveraged entities
that play important roles in both the primary and secondary markets. In-
vestment banking activities include:

■Raising funds through public offerings and private placement ofsecurities.
■Trading of securities.
■Mergers, acquisitions, and ﬁnancial restructuring advising.
■Merchant banking.
■Securities ﬁnance and prime brokerage services.
The ﬁrst role is assisting in the raising of funds by corporations, U.S.
government agencies, state and local governments, and foreign entities

(sovereigns and corporations). The second role is assisting investors whowish to invest funds by acting as brokers or dealers in secondary market
transactions.
We can classify investment banking into two categories:
1.Companies afﬁliated with large ﬁnancial services holding companies.
2.Companies that are independent of a large ﬁnancial services holdingcompany.
The large investment banks are afﬁliated with large commercial bank

holding companies. Examples of bank holding companies, referred to as
bank-afﬁliated investment banks, are Banc of America Securities (a sub-sidiary of Bank of America), JPMorgan Securities (a subsidiary of JPMor-
gan Chase), and Wachovia Securities (a subsidiary of Wells Fargo), and
Goldman Sachs.
The second category of investment banks, referred to as independent
investment banks, is a shrinking group. As of mid-2008, this group includesGreenhill & Company and Houlihan Lokey Howard & Zukin.

The Financial System’s Cast of Characters 57
Another way of classifying investment banking companies is based on
the types of activities (i.e., the lines of business) in which they participate:
full-service investment banks and boutique investment banks. The former
are active in a wide range of investment banking activities while the latter

specialize in a limited number of those activities.
In assisting entities in the raising of funds in the public market, invest-
ment bankers perform one or more of the following three functions:
■Advising the issuer on the terms and the timing of the offering.
■Underwriting.
■Distributing the issue to the public.
In their advisory role, investment bankers may be required to design a
security structure that is more appealing to investors than currently available
ﬁnancial instruments.

The underwriting function involves the way in which the investment
bank agrees to place the newly issued security in the market on behalfof the issuer. The fee earned by the investment banking company from
underwriting is the difference between the price it paid to the issuer forthe security and the price it reoffers the security to the public (called the
reoffering price). This difference is referred to as the gross spread . There

are two types of underwriting arrangements: ﬁrm commitment and best
efforts. In a ﬁrm commitment arrangement , the investment bank purchases
the newly issued security from the issuer at a ﬁxed price and then sells thesecurity to the public at the reoffering price. In a best-efforts underwriting
arrangement , the investment banking ﬁrm does not buy the newly issued

security from the issuer. Instead, it agrees only to use its expertise to sell thesecurity to the public and earns the gross spread on only what it can sell.
Typically in a ﬁrm-commitment underwriting there will be several in-
vestment banks involved because of the capital commitment that must bemade and the potential loss of the company’s capital if the newly issued
security cannot be sold to the public at a higher price than the purchase

price. This is done by forming a group of companies to underwrite the issue,referred to as an underwriting syndicate by the lead underwriter or under-
writers. The gross spread is then divided among the lead underwriter(s) andthe other companies in the underwriting syndicate.
The distribution function is critical to both the issuer and the investment

bank. To realize the gross spread, the entire securities issue must be sold tothe public at the planned reoffering price and, depending on the size of theissue, may require a great deal of marketing effort. The members of the
underwriting syndicate will sell the newly issued security to their investor
client base. To increase the potential investor base, the lead underwriter(s)

58 THE FINANCIAL SYSTEM
will often put together a selling group. This group includes the underwriting
syndicate plus other companies not in the syndicate with the gross spread
then divided among the lead underwriter(s), members of the underwritingsyndicate, and members of the selling group.
Private Placement of Securities As an alternative to issuing a new se-

curity in the public market, a company can issue a security via a private
placement to a limited number of institutional investors such as insurancecompanies, investment companies, and pension funds. Private placement
offerings are distinguished by type: non-Rule 144A offerings (traditional
private placements) and Rule 144A offerings. Rule 144A offerings are un-derwritten by investment bankers.
Trading Securities An obvious activity of investment banks is provid-

ing transaction services for clients. Revenue is generated on transactions in
which the investment bank acts as an agent or broker in the form of a com-mission. In such transactions, the investment bank is not taking a position
in the transaction, meaning that it is not placing its own capital at risk. In
other transactions, the investment bank may act as a market maker, plac-ing its own capital at risk. Revenue from this activity is generated through

(1) the difference between the price at which the investment bank sells the
security and the price paid for the securities (called the bid-ask spread); and(2) appreciation of the price of the securities held in inventory. (Obviously,
if the price of the securities decline, revenue will be reduced.)
In addition to executing trades in the secondary market for clients,

as well as market making in the secondary market, investment banks doproprietary trading (referred to as prop trading ). In this activity, the in-
vestment bank’s traders position some of the company’s capital to bet onmovements in the price of ﬁnancial instruments, interest rates, or foreign
exchange.
Advising in Mergers, Acquisitions, and Financial Restructuring Advising
Investment banks are active in mergers and acquisitions (M&A), leveraged

buyouts (LBOs), restructuring and recapitalization of companies, and re-
organization of bankrupt and troubled companies. They do so in one ormore of the following ways: (1) identifying candidates for a merger or ac-
quisition, M&A candidates; (2) advising the board of directors of acquiring
companies or target companies regarding price and nonprice terms for anexchange; (3) assisting companies that are the target of an acquisition to

fend off an unfriendly takeover attempt; (4) helping acquiring companies
to obtain the needed funds to complete an acquisition; and (5) providing a

The Financial System’s Cast of Characters 59
“fairness opinion” to the board of directors regarding a proposed merger,
acquisition, or sale of assets.
Another area where investment banks advise is on a signiﬁcant

modiﬁcation of a corporation’s capital structure, operating structure,and/or corporate strategy with the objective of improving efﬁciency. Suchmodiﬁcations are referred to as ﬁnancial restructuring of a company. This
may be the result of a company seeking to avoid a bankruptcy, avoid aproblem with creditors, or reorganize the company as permitted by the U.S.bankruptcy code.
The activities described above generate fee income that can either be a

ﬁxed retainer or in the case of consummating a merger or acquisition, a feebased on the size of the transaction. Thus, for most of these activities, the
investment bank’s capital is not at risk. However, if the investment bank
provides ﬁnancing for an acquisition, it does place its capital at risk. This
brings us to the activity of merchant banking.
Merchant Banking The activity of merchant banking is one in which the
investment bank commits its own capital as either a creditor or to take

an equity stake. There are divisions or groups within an investment bank
devoted to merchant banking. In the case of equity investing, this may be inthe form of a series of private equity funds.
Securities, Finance, and Prime Brokerage Services There are clients
of investment banks that, as part of their investment strategy, may need
to either (1) borrow funds in order to purchase a security or (2) borrow
securities in order to sell a security short or to cover a short sale. The

standard mechanism for borrowing funds in the securities market is via arepurchase agreement (referred to as a repo) rather through bank borrowing.
A repo is a collateralized loan where the collateral is the security purchased.Investment banks earn interest on repo transactions. A customer can borrowa security in a transaction known as a securities lending transaction. In such

transactions, the lender of the security earns a fee for lending the securities.The activity of borrowing funds or borrowing securities is referred to as
securities ﬁnance.
Investment banks may provide a package of services to hedge fund and
large institutional investors. This package of services, referred to as prime
brokerage, includes securities ﬁnance that we just described as well as global
custody, operational support, and risk management systems.

Asset Management An investment bank may have one or more sub-
sidiaries that manage assets for clients such as insurance companies, endow-
ments, foundations, corporate and public pension funds, and high-net-worth

60 THE FINANCIAL SYSTEM
individuals. These asset management divisions may also manage mutual
funds and hedge funds. Asset management generates fee income based on apercentage of the assets under management.
FOREIGN INVESTORS
The sector referred to as foreign investors includes individuals, nonﬁnancial

business, and ﬁnancial entities that are not domiciled in the United States,as well as foreign central governments and supranationals. A foreign central
bank is a monetary authority of the foreign country, such as the People’s
Bank of China (PBC), the European Central Bank, and the Bank of Canada.Foreign central banks participate in the U.S. ﬁnancial market for two rea-
sons. The ﬁrst reason is to stabilize their currency relative to the U.S. dollar.

The second reason is to purchase a ﬁnancial instrument with excess fundsbecause it is perceived to be an attractive investment vehicle.
Asupranational institution is an international entity that is created by
two or more central governments through international treaties. We candivide supranationals into two categories: multilateral development banks
and others. The former are supranational ﬁnancial institutions with the

mandate to provide ﬁnancial assistance with funds obtained from membercountries to developing countries and to promote regional integration in
speciﬁc geographical regions. The largest multilateral development banks are
the European Investment Bank with more than $300 billion in total assets
and the International Bank for Reconstruction and Development (popularly

referred to as the World Bank) with more than $250 billion in total assets.The next two largest, the Inter-American Development Bank and Asian
Development Bank, have less than a third of the assets of the two largest
multilateral development banks.
■The ﬁnancial system is comprised of ﬁnancial ﬁrms, governmental en-
tities, nonﬁnancial business entities, households, and nonproﬁt entities.
The largest sector in the system consists of nonﬁnancial business entities.

■Government entities in the ﬁnancial system include federal, state, and
local governments, as well as government-owned and government-
sponsored enterprises.
■The ﬁnancial sector in the economy is comprised of depository insti-
tutions, nondepository ﬁnancial institutions, insurance companies, and
investment companies.

The Financial System’s Cast of Characters 61
■The principal services provided by commercial banks are individual
banking, institutional banking, and global banking.
■Insurance companies are risk bearers or are the underwriters of risk
for a wide range of insurable events, and are major participants in the
ﬁnancial market as investors.

■Investment companies manage the funds of individuals, businesses, and
state and local governments, and are compensated for this service by fees
that they charge. The types of accounts, clients, and lines of business ofasset management companies include regulated investment companies,
exchange-traded funds, hedge funds, separately managed accounts, and
pension funds.
■Investment banks play important roles in both the primary and sec-

ondary markets, and their activities include raising funds through pub-
lic offerings and private placement of securities; trading of securities;
advising on mergers, acquisitions, and ﬁnancial restructuring; merchant
banking; and securities ﬁnance and prime brokerage services.
■Foreign investors include individuals, nonﬁnancial business, and ﬁnan-
cial entities that are not domiciled in the United States, as well as foreign
central governments and supranational institutions.
QUESTIONS

QUESTIONS
1.Who are the players in the government sector?
2.What is the distinction between a government-owned corporation anda government-sponsored enterprise?
3.What is the distinction between a depository ﬁnancial institution and a
nondepository bank ﬁnancial institution?
4.What is an excess reserve and how is this different than required re-
serves?
5.List at least four different types of insurance companies.
6.What is the difference between a mutual fund and a closed-end fund?

7.If a mutual fund has a portfolio with a market value of $1 million andliabilities of $0.2 million, what is the net asset value if the fund has0.5 million shares?
8.List two advantages, from the investor point of view, of an exchangetraded fund, vis- `a-vis a closed-end fund?
9.Distinguish between a deﬁned beneﬁt pension plan and a deﬁned con-
tribution plan.
10.List at least three functions of an investment bank.
11.List the major types of depository institutions.

12.How do commercial banks obtain their funds?
13.What is ﬁnancial restructuring advising? Provide an example.

62 THE FINANCIAL SYSTEM
14.The following is an excerpt from the 2009 Annual Report of Bank of
America (p. 24):
Through our banking and various nonbanking subsidiariesthroughout the United States and in selected international mar-kets, we provide a diversiﬁed range of banking and nonbanking
ﬁnancial services and products through six business segments:

Deposits, Global Card Services, Home Loans & Insurance,Global Banking, Global Markets and Global Wealth & Invest-
ment Management.
a.What is meant by “Global Banking”?
b.What is meant by “Global Wealth & Investment Management”?
15.The following excerpt if from the notes to the ﬁnancial statements inthe 2009 Annual Report of Bank of America (p. 147):
The Corporation enters into trading derivatives to facilitateclient transactions for proprietary trading purposes, and to

manage risk exposures arising from trading assets and liabil-ities.
a.What is meant by “proprietary trading”?
16.Following is an excerpt from “Merchant Banking: Past and Present” by
Valentine V. Craig, published by the Federal Deposit Insurance Corpo-
ration (www.fdic.gov/bank/analytical/banking/2001sep/article2.html):
Merchant banking has been a very lucrative—and risky—endeavor for the small number of bank holding companiesand banks that have engaged in it under existing law. Recent

legislation has expanded the merchant-banking activity that is
permissible to commercial banks and is therefore likely to spur
interest in this lucrative specialty on the part of a greater num-
ber of such institutions.
a.What is meant by “merchant banking”?
b.What are the risks associated with merchant banking?

c04 JWBT310-Fabozzi July 1, 2010 11:11 Printer: Courier Westford, Westford, MA
PARTTwo
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64

CHAPTER4
Financial Statements
Three suggestions for investors: First, beware of companies
displaying weak accounting. If a company still does not expense
options, or if its pension assumptions are fanciful, watch out.
When managements take the low road in aspects that are visible, itis likely they are following a similar path behind the scenes. There

is seldom just one cockroach in the kitchen. ...
Second, unintelligible footnotes usually indicate untrustworthy
management. If you can’t understand a footnote or othermanagerial explanation, it’s usually because the CEO doesn’t want
you to. Enron’s descriptions of certain transactions still bafﬂe me.
Finally, be suspicious of companies that trumpet earnings

projections and growth expectations. Businesses seldom operate ina tranquil, no-surprise environment, and earnings simply don’tadvance smoothly (except, of course, in the offering books of
investment bankers).
Hathaway, February 21, 2003
Financial statements are summaries of the operating, ﬁnancing, and in-
vestment activities of a business. Financial statements should provide

information useful to both investors and creditors in making credit, invest-
ment, and other business decisions. And this usefulness means that investors
and creditors can use these statements to predict, compare, and evaluate
the amount, timing, and uncertainty of future cash ﬂows. In other words,
ﬁnancial statements provide the information needed to assess a company’sfuture earnings and, therefore, the cash ﬂows expected to result from those

earnings. In this chapter, we discuss the four basic ﬁnancial statements: the
balance sheet, the income statement, the statement of cash ﬂows, and thestatement of shareholders’ equity.
65

66 FINANCIAL MANAGEMENT
ACCOUNTING PRINCIPLES: WHAT ARE THEY?
The accounting data in ﬁnancial statements are prepared by the company’s
management according to a set of standards, referred to as generally
accepted accounting principles (GAAP). Generally accepted accounting

principles are based on the codiﬁed standards promulgated by the FinancialAccounting Standards Board (FASB), as part of the FASB Accounting
Standards Codiﬁcation.
1
The ﬁnancial statements of a company whose stock is publicly traded
must, by law, be audited at least annually by independent public accountants
(i.e., accountants who are not employees of the company). In such an audit,

the accountants examine the ﬁnancial statements and the data from whichthese statements are prepared and attest—through the published auditor’s
opinion—that these statements have been prepared according to GAAP. In
this case, GAAP includes not only the FASB Accounting Standards Codiﬁ-
cation, but any rules and regulations of the Securities and Exchange Com-

mission. The auditor’s opinion focuses whether the statements conform toGAAP and that there is adequate disclosure of any material change in ac-
counting principles.
The ﬁnancial statements and the auditors’ ﬁndings are published in the
company’s annual and quarterly reports sent to shareholders and the 10-Kand 10-Q ﬁlings with the Securities and Exchange Commission (SEC). Also

included in the reports, among other items, is a discussion by management,entitled “Management’s Discussion and Analysis of Financial Conditions
and Results of Operations,” which is an overview of company events. The
annual reports are much more detailed and disclose more ﬁnancial informa-tion than the quarterly reports.
Assumptions in Creating Financial Statements
The ﬁnancial statements are created using several assumptions that affecthow we use and interpret the ﬁnancial data:

■Transactions are recorded at historical cost. Therefore, the values shown
in the statements are not market or replacement values, but rather reﬂectthe original cost (adjusted for depreciation in the case of a depreciable
assets).
1Prior to Financial Accounting Standards Board Statement of Financial Accounting
Standards No. 168, GAAP was a subject to a hierarchy of sources of principles,
but this has been simpliﬁed, effective for companies with ﬁscal years ending after
September 15, 2009.

Financial Statements 67
■The appropriate unit of measurement is the dollar. While this seems
logical, the effects of inﬂation, combined with the practice of recording
values at historical cost, may cause problems in using and interpreting
these values.
■The statements are recorded for predeﬁned periods of time . Generally,

statements are produced to cover a chosen ﬁscal year or quarter, with theincome statement and the statement of cash ﬂows spanning a period’s
time and the balance sheet and statement of shareholders’ equity asof the end of the speciﬁed period. But because the end of the ﬁscal
year is generally chosen to coincide with the low point of activity in the
operating cycle, the annual balance sheet and statement of shareholders’equity may not be representative of values for the year.

■Statements are prepared using accrual accounting and the matchingprinciple. Most businesses use accrual accounting, where income and
revenues are matched in timing so that income is recorded in the periodin which it is earned and expenses are reported in the period in whichthey are incurred in an attempt to generate revenues. The result of the
use of accrual accounting is that reported income does not necessarily
coincide with cash ﬂows.

■The business will continue as a going concern. The assumption that the
business enterprise will continue indeﬁnitely justiﬁes the appropriatenessof using historical costs instead of current market values because theseassets are expected to be used up over time instead of sold.
■There is full disclosure . Full disclosure requires providing information

beyond the ﬁnancial statements. The requirement that there be full dis-closure means that, in addition to the accounting numbers for such
accounting items as revenues, expenses, and assets, narrative and ad-
ditional numerical disclosures are provided in notes accompanying theﬁnancial statements. An analysis of ﬁnancial statements is, therefore,
not complete without this additional information.

■Statements are prepared assuming conservatism. In cases in which morethan one interpretation of an event is possible, statements are prepared
using the most conservative interpretation.
THE BASIC FINANCIAL STATEMENTS
The basic ﬁnancial statements are the balance sheet, the income statement,the statement of cash ﬂows, and the statement of shareholders’ equity. Thebalance sheet is a report of what the company has—assets, debt, and equity—

as of the end of the ﬁscal quarter or year, and the income statement is a
report of what the company earned during the ﬁscal period. The statementof cash ﬂows is a report of the cash ﬂows of the company over the ﬁscal

68 FINANCIAL MANAGEMENT
period, whereas the statement of shareholders’ equity is a reconciliation of
the shareholders’ equity from one ﬁscal year end to another.
The Balance Sheet
Thebalance sheet is a report of the assets, liabilities, and equity of a com-
pany at a point in time, generally at the end of a ﬁscal quarter or ﬁscal

year. Assets are resources of the business enterprise, which are comprised of
current or long-lived assets. How did the company ﬁnance these resources?
It did so with liabilities and equity. Liabilities are obligations of the business
enterprise that must be repaid at a future point in time, whereas equity is the
ownership interest of the business enterprise. The relation between assets,liabilities and equity is simple, as reﬂected in the balance of what is owned

and how it is ﬁnanced, referred to as the accounting identity:
Liabilities Assets Equity
Assets Assets are anything that the company owns that has a value. These
assets may have a physical in existence or not. Examples of physical assetsinclude inventory items held for sale, ofﬁce furniture, and production equip-
ment. If an asset does not have a physical existence, we refer to it as anintangible asset, such as a trademark or a patent. You cannot see or touch

an intangible asset, but it still contributes value to the company.
Assets may also be current or long-term, depending on how fast the
company would be able to convert them into cash. Assets are generallyreported in the balance sheet in order of liquidity, with the most liquid asset
listed ﬁrst and the least liquid listed last.
The most liquid assets of the company are the current assets. Current
assets are assets that can be turned into cash in one operating cycle or one

year, whichever is longer. This contrasts with the noncurrent assets, whichcannot be liquidated quickly.
There are different types of current assets. The typical set of current
assets is the following:
■Cash, bills, and currency are assets that are equivalent to cash (e.g.,
bank account).
■Marketable securities , which are securities that can be readily sold.

Financial Statements 69
■Accounts receivable, which are amounts due from customers arising
from trade credit.
■Inventories, which are investments in raw materials, work-in-process,
and ﬁnished goods for sale.
A company’s need for current assets is dictated, in part, by its operating
cycle. The operating cycle is the length of time it takes to turn the investment

of cash into goods and services for sale back into cash in the form of collec-
tions from customers, as we display in Exhibit 4.1. The longer the operating
cycle, the greater a company’s need for liquidity. Most companies’ operating
cycle is less than or equal to one year.
Noncurrent assets comprise both physical and nonphysical assets. Plant

assets are physical assets, such as buildings and equipment and are reﬂectedin the balance sheet as gross plant and equipment and net plant and equip-ment. Gross plant and equipment ,o rgross property, plant, and equipment ,
is the total cost of investment in physical assets; that is, what the companyoriginally paid for the property, plant, and equipment that it currently owns.
Net plant and equipment ,o rnet property, plant, and equipment , is the dif-

ference between gross plant and equipment and accumulated depreciation,
and represents the book value of the plant and equipment assets. Accumu-
lated depreciation is the sum of depreciation taken for physical assets in the
company’s possession.
Collect
payment on
credit accounts
CashInvest cash in
inventorySell goods on
credit
EXHIBIT 4.1 The Operating Cycle

70 FINANCIAL MANAGEMENT
EXHIBIT 4.2 ABC Company Balance Sheets
December 31, 2009 December 31, 2008
Cash $ 50 $ 100
Accounts receivable 700 600
Inventory 750 800
Total current assets $ 1,500 $ 1,500
Gross plant and equipment $12,000 $10,000
Accumulated depreciation 4,000 3,000
Net plant and equipment $ 8,000 $ 7,000
Intangible assets 500 500
Total assets $10,000 $ 9,000

Accounts payable $ 350 $ 300
Wages payable 150 100
Total current liabilities $ 500 $ 400
Long-term debt $ 6,660 $ 6,660
Common stock 100 100
Additional paid-in capital 600 600
Retained earnings 2,240 1,340
Treasury stock 200 200
Accumulated other comprehensive
income or loss 100 100
Shareholders’ equity 2,840 1,940
Total liabilities and equity $10,000 $ 9,000
Companies may present just the net plant and equipment ﬁgure on the

balance sheet, placing the detail with respect to accumulated depreciation in
a footnote. Interpreting ﬁnancial statements requires knowing a bit about
how assets are depreciated for ﬁnancial reporting purposes. Depreciation is
the allocation of the cost of an asset over its useful life (or economic life).In the case of the ﬁctitious ABC Company, whose balance sheet is shown

in Exhibit 4.2, the original cost of the ﬁxed assets (i.e., property, plant,and equipment)—less any write-downs for impairment—for the year 2009
is $900 million. The accumulated depreciation for ABC in 2009 is $250
million; this means that the total depreciation taken on existing ﬁxed assetsover time is $270 million. The net property, plant, and equipment account
balance is $630 million. This is also referred to as the book value orcarrying
value of these assets.

Intangible assets are assets that are not ﬁnancial instruments, yet have
no physical existence, such as patents, trademarks, copyrights, franchises,

Financial Statements 71
and formulae. Intangible assets may be amortized over some period, which
is akin to depreciation. Keep in mind that a company may own a number ofintangible assets that are not reported on the balance sheet. A company may
only include an intangible asset’s value on its balance sheet if (1) there are

likely future beneﬁts attributable speciﬁcally to the asset, and (2) the cost ofthe intangible asset can be measured.
Suppose a company has an active, ongoing investment in research and
development to develop new products. It must expense what is spent onresearch and development each year because for a given investment in R&D
does not likely meet the two criteria because it is not until much later,

after the R&D expense is made, that the economic viability of the invest-ment is determined. If, on the other hand, a company buys a patent from
another company, this cost may be capitalized and then amortized over
the remaining life of the patent. So when you look at a company’s assets
on its balance sheet, you may not be getting the complete picture of what
it owns.
Liabilities We generally use the terms “liability” and “debt” as synony-

mous terms, though “liability” is actually a broader term, encompassing
not only the explicit contracts that a company has, in terms of short-term
and long-term debt obligations, but also includes obligations that are notspeciﬁed in a contract, such as environmental obligations or asset retire-
ment obligations. Liabilities may be interest-bearing, such as a bond issue,
or noninterest bearing, such as amounts due to suppliers.

In the balance sheet, liabilities are presented in order of their due
date and are often presented in two categories, current liabilities andlong-term liabilities. Current liabilities are obligations due within one
year or one operating cycle (whichever is longer). Current liabilities may
consist of:
■Accounts payable, amounts due to suppliers for purchases on credit;
■Wages and salaries payable, amounts due employees;
■Current portion of long-term indebtedness; and
■Short term bank loans.

Long-term liabilities are obligations that are due beyond one year. There
are different types of long-term liabilities, including:
■Notes payables andbonds, which are indebtedness (loans) in the form
of securities;

72 FINANCIAL MANAGEMENT
■Capital leases , which are rental obligations that are long-term, ﬁxed
commitments;
■Asset retirement liability, which is the contractual or statutory obliga-
tion to retire or decommission an asset at the end of the asset’s life and
restore the site to required standards; and
■Deferred taxes , which are taxes that may have to be paid in the future

that are currently not due, though they are expensed for ﬁnancial report-ing purposes. Deferred taxes arise from differences between accounting
and tax methods (e.g., depreciation methods).
2
Equity The equity of a company is the ownership interest. The book value
of equity, which for a corporation is often referred to as shareholders’ equity
or stockholders’ equity, is basically the amount that investors paid the com-

pany for their ownership interest, plus any earnings (or less any losses), andminus any distributions to owners. For a corporation, equity is the amount
that investors paid the corporation for the stock when it was initially sold,
plus or minus any earnings or losses, less any dividends paid. Keep in mindthat for any company, the reported amount of equity is an accumulation
over time since the company’s inception (or incorporation, in the case of a
corporation).

Shareholders equity is the carrying or book value of the ownership of a
company. Shareholders’ equity is comprised of:
■Par value, which is a nominal amount per share of stock (sometimesprescribed by law), or the stated value, which is a nominal amount per
share of stock assigned for accounting purposes if the stock has no parvalue;
■Additional paid-in capital ,a l s or e f e r r e dt oa scapital surplus , the amount

paid for shares of stock by investors in excess of par or stated value;
■Retained earnings, which is the accumulation of prior and current pe-riods’ earnings and losses, less any prior or current periods’ dividends;
and
■Accumulated comprehensive income or loss, which is the total amount
of income or loss that arises from transactions that result in income or
losses, yet are not reported through the income statement. Items giving

2Similar to deferred tax liabilities, there is also a possibility that the company has
a deferred tax asset, which is a tax beneﬁt expected in the future. For example, if
a company has net operating losses that it will likely apply against future taxable
income, the deferred tax asset is the amount by which future tax bills are likely to
be reduced.

Financial Statements 73
rise to this income include foreign currency translation adjustments and
unrealized gains or losses on available-for-sale investments.
In addition, a company that buys back its own stock from shareholders
may retain this stock for use in employee stock options. The account that
represents this stock is Treasury stock. This is a deduction from the other

accounts to arrive at shareholders’ equity.
A Note on Minority Interest On many companies’ consolidated ﬁnancial
statements, you will notice a balance sheet account entitled “Minority In-
terest” as an account in shareholders’ equity. When a company owns a
substantial portion of another company, accounting principles require that
the company consolidate that company’s ﬁnancial statements into its own.Basically what happens in consolidating the ﬁnancial statements is that the

parent company will add the accounts of the subsidiary to its accounts (i.e.,
subsidiary inventory +parent inventory =consolidated inventory).
3If the
parent does not own 100% of the subsidiary’s ownership interest, an ac-
count is created, referred to as minority interest , which reﬂects the amount
of the subsidiary’s assets notowned by the parent.
Prior to 2009, this account was presented between liabilities and equity
on the consolidated balance sheet. However, from 2009 forward, companies

are required to report this amount in shareholders’ equity as equity. But
is minority interest considered equity? No. Therefore, when we analyze a
company’s ﬁnancial statement, we remove minority interest from equity. Ifwe leave this account in equity, we will risk distorting measures of how a
company ﬁnances itself.
A similar adjustment takes place on the income statement. The minority

interest account on the income statement reﬂects the income (or loss) inproportion to the equity in the subsidiary notowned by the parent. Begin-
ning with 2009 ﬁnancial statements, companies are not required to subtract
minority interest from their earnings, but need only disclose whether these
earnings are in reported the parent company’s net income.
Under the new rules, some companies may choose to report two different

amounts for net income (total and parent-only), whereas other companiesmay simply report one net income ﬁgure and footnote the minority interest.
In the former case, we would use the net income after adjusting for minorityearnings. In the latter case, we need to subtract minority interest earnings
from reported net income.
3There are some other adjustments that are made for inter-corporate transactions,
but we won’t discuss those here.

74 FINANCIAL MANAGEMENT
Structure of the Balance Sheet Consider a simple balance sheet for the
ABC Company shown in Exhibit 4.2 for two ﬁscal years. A few items to
note:
■The accounting identity holds; that is, total assets are equal to the sumof the total liabilities and the total shareholders’ equity.
■The asset accounts are ordered from the most liquid to the least liquid.

■The liabilities are listed in order of priority of claims, with trade creditorsand employees having the best claims.
The Income Statement
Theincome statement is a summary of operating performance over a period
of time (e.g., a ﬁscal quarter or a ﬁscal year). We start with the revenue of
the company over a period of time and then subtract the costs and expenses

related to that revenue. The bottom line of the income statement consistsof the owners’ earnings for the period. To arrive at this “bottom line,” we
need to compare revenues and expenses. We provide the basic structure of
the income statement in Exhibit 4.3.
Though the structure of the income statement varies by company, the
basic idea is to present the operating results ﬁrst, followed by non-operatingresults. The cost of sales ,a l s or e f e r r e dt oa st h e cost of goods sold , is deducted

from revenues, producing a gross proﬁt; that is, a proﬁt without considering
all other general operating costs. These general operating expenses are those
expenses related to the support of the general operations of the company,which includes salaries, marketing costs, and research and development.
Depreciation, which is the amortized cost of physical assets, is also deducted

from gross proﬁt. The amount of the depreciation expense represents the costof the wear and tear on the property, plant, and equipment of the company.
Once we have the operating income, we have summarized the company’s
performance with respect to the operations of the business. But there is
generally more to the company’s performance. From operating income, we

deduct interest expense and add any interest income. Further, adjustmentsare made for any other income or cost that is not a part of the company’s
core business.
There are a number of other items that may appear as adjustments to
arrive at net income. One of these is extraordinary items, which are deﬁnedas unusual and infrequent gains or losses. Another adjustment would be for
the expense related to the write-down of an asset’s value.

In the case of the ABC Company, whose income statement we provide
in Exhibit 4.4, the income from operations—its core business—is $2,000million, whereas the net income (i.e., the “bottom line”) is $1,000 million.

Financial Statements 75
EXHIBIT 4.3 The Basic Structure of the Income Statement
Revenues or sales Represent the amount of goods or services
sold, in terms of price paid by customers
– Cost of goods sold The amount of goods or services sold, in
terms of cost to the company
Gross proﬁt The difference between sales and cost of
goods sold
– Selling and general

goods sold
administrative expensesSalaries, administrative, marketing
expenditures, etc.
Operating proﬁt Income from operations; earnings before
interest and taxes (EBIT), operating income,
and operating earnings
– Interest expense Interest paid on debt
Income before taxes Earnings before taxes
– Tax expense Taxes expense for the current period
Net income Operating proﬁt less ﬁnancing expenses
(e.g., interest) and taxes

– Preferred stock dividends Dividends paid to preferred shareholders
Earnings available to common
shareholdersNet income less preferred stock dividends;
residual income
Earnings Per Share Companies provide information on earnings per share
(EPS) in their annual and quarterly ﬁnancial statement information, as well
as in their periodic press releases. Generally, EPS is calculated as net incomedivided by the number of shares outstanding. Companies must report both

basic and diluted earnings per share.
EXHIBIT 4.4
The ABC Company Income Statement for the
periods ending December 31, 2008 and 2009 (in millions)
Revenues or sales $10,000
Cost of goods sold 7,000
Gross proﬁt $ 3,000
Selling and general administrative expenses 1,000
Operating proﬁt $ 2,000
Interest expense 333
Income before taxes $ 1,667
Tax expense 667
Net income $ 1,000

76 FINANCIAL MANAGEMENT
Basic earnings per share is net income (minus preferred dividends) di-
vided by the average number of shares outstanding. Diluted earnings per
share is net income (minus preferred dividends) divided by the number of
shares outstanding considering all dilutive securities (e.g., convertible debt,

options).4Diluted earnings per share, therefore, gives the shareholder in-
formation about the potential dilution of earnings. For companies with a
large number of dilutive securities (e.g., stock options, convertible preferredstock, or convertible bonds), there can be a signiﬁcant difference between
basic and diluted EPS. You can see the effect of dilution by comparingthe basic and diluted EPS.
More on Depreciation There are different methods that can be used to

allocate an asset’s cost over its life. Generally, if the asset is expected to
have value at the end of its economic life, the expected value, referred
to as a salvage value (orresidual value), is not depreciated; rather, the asset
is depreciated down to its salvage value. There are different methods of
depreciation that we classify as either straight-line or accelerated.
■Straight-line depreciation allocates the cost (less salvage value) in a uni-

form manner (equal amount per period) throughout the asset’s life.
■Accelerated depreciation allocates the asset’s cost (less salvage value)
such that more depreciation is taken in the earlier years of the asset’slife.
There are alternative accelerated methods available, including:
■Declining balance method , in which a constant rate applied to a declin-
ingamount (the undepreciated cost).
■Sum-of-the-years’ digits method , in which a declining rate applied to

the asset’s depreciable basis and this rate is ratio of the remaining years
divided by the sum of the years.5
Accelerated methods result in higher depreciation expenses in earlier
years, relative to straight-line. As a result, accelerated methods result in
lower reported earnings in earlier years, relative to straight-line, but also
lower net property, plant, and equipment in earlier years as well.
Comparing companies, it is important to understand whether the

companies use different methods of depreciation because the choice ofdepreciation method affects both the balance sheet (through the carrying
4In the case of diluted earnings per share, if the dilution potential is from convertible
debt, earnings are adjusted for the interest on this convertible debt.
5For example, for an asset with a ﬁve year life, the ﬁrst year’s depreciation is 5/15,
the second year’s depreciation is 4/15, and so on.

Financial Statements 77
value of the asset) and the income statement (through the depreciation ex-
pense).
A major source of deferred income tax liability and deferred tax assets

is the accounting method used for ﬁnancial reporting purposes and taxpurposes. In the case of ﬁnancial accounting purposes, the company choosesthe method that best reﬂects how its assets lose value over time, though
most companies use the straight-line method. However, for tax purposes
the company has no choice but to use the prescribed rates of depreciation,using the Modiﬁed Accelerated Cost Recovery System (MACRS). For tax

purposes, a company does not have discretion over the asset’s depreciablelife or the rate of depreciation—they must use the MACRS system.
The MACRS system does not incorporate salvage value and is based
on a declining balance system. The depreciable life for tax purposes may belonger than or shorter than that used for ﬁnancial reporting purposes. We
provide the MACRS rates for 3, 5, 7 and 10-year assets in Exhibit 4.5.
You’ll notice the fact that a 3-year asset is depreciated over four years

and a 5-year asset is depreciated over six years, and so on. That is the resultof using what is referred to as a half-year convention—using only half a
year’s worth of depreciation in the ﬁrst year of an asset’s life. This system
results in a leftover amount that must still be depreciated in the last year
(i.e., the fourth year in the case of a 3-year asset and the sixth year in the
case of a 5-year asset).
We can compare MACRS with straight-line, using an example of an

asset that costs $100,000 that has an eight-year useful life but is classiﬁedas a 7-year MACRS asset for tax purposes. If the company uses straight-line
EXHIBIT 4.5
MACRS Rates
MACRS Life, in Years
Year 3-year 5-year 7-year 10-year
1 33.33% 20.00% 14.29% 10.00%
2 44.44% 32.00% 24.49% 18.00%
3 14.81% 19.20% 17.49% 14.40%
4 7.41% 11.52% 12.49% 11.52%
5 11.52% 8.92% 9.22%
6 5.76% 8.92% 7.37%
7 8.92% 6.55%
8 4.46% 6.55%
9 6.55%
10 6.55%
11 3.28%

78 FINANCIAL MANAGEMENT
depreciation for ﬁnancial reporting purposes, there will be a difference in
income and tax expense for tax and ﬁnancial reporting purposes.
Let’s assume that the asset has no salvage value, that the company has

net income before taxes and depreciation of $50,000, and that the tax rateis 30%. The amount depreciated is the same under both methods, but theannual depreciation is different:
Depreciation Rate Depreciation Expense
Year MACRS Straight-line MACRS Straight-line
1 14.29% 12.50% $ 14,286 $ 12,500
2 24.49% 12.50% $ 24,490 $ 12,500
3 17.49% 12.50% $ 17,493 $ 12,500
4 12.49% 12.50% $ 12,495 $ 12,500
5 8.92% 12.50% $ 8,925 $ 12,500
6 8.92% 12.50% $ 8,925 $ 12,500
7 8.92% 12.50% $ 8,925 $ 12,500

8 4.46% 12.50% $ 4,462 $ 12,500
Sum $100,000 $100,000
Therefore, the difference in these methods is not the total that is de-
preciated, but rather the timing of the depreciation. The effects on taxableincome and tax expense are also a matter of timing:
Taxable Income Tax Expense
1 $ 35,714 $ 37,500 $10,714 $11,250
2 $ 25,510 $ 37,500 $ 7,653 $11,250

3 $ 32,507 $ 37,500 $ 9,752 $11,2504 $ 37,505 $ 37,500 $11,252 $11,250
5 $ 41,075 $ 37,500 $12,323 $11,250
6 $ 41,075 $ 37,500 $12,323 $11,2507 $ 41,075 $ 37,500 $12,323 $11,250
8 $ 45,538
$ 37,500 $13,661 $11,250
Sum $300,000 $300,000 $90,000 $90,000

Financial Statements 79
In this example, the company would have a deferred tax liability cre-
ated when MACRS tax expense is less than the straight-line tax expense,
but this would reverse in later years—reducing the deferred tax liability—as
the tax expense using straight-line is less than the tax expense under
MACRS.
TRY IT! MACRS DEPRECIATION

MACRS.
Suppose a company acquires an asset at the end of 2010 that has a
cost of $20,000 and is classiﬁed as a 3-year MACRS asset. What is the
depreciation expense each year?
The Statement of Cash Flows
The statement of cash ﬂows is the summary of a company’s cash ﬂows,
summarized by operations, investment activities, and ﬁnancing activities.We provide a simpliﬁed cash ﬂow statement in Exhibit 4.6 for the ﬁctitious
EXHIBIT 4.6
Statement of Cash Flows for ABC Company

for ﬁscal year ending December 31, 2009
Operating activities
Net income $1,000
Add: Depreciation 1,000
Subtract: increase in accounts receivable −100
Add: Decrease in inventory +50
Add: Increase in accounts payable +50
Add: Increase in wages payable +50
Cash ﬂow from operations $2,050
Investing activities
Capital expenditures −$2,000
Cash ﬂow from investing −$2,000
Financing activities
Dividends paid −$ 100
Cash ﬂow from ﬁnancing −$ 100

80 FINANCIAL MANAGEMENT
ABC Company. Cash ﬂow from operations is cash ﬂow from day-to-day
operations. Cash ﬂow from operating activities is basically net income ad-
justed for (1) noncash expenditures, and (2) changes in working capitalaccounts.
The adjustment for changes in working capital accounts is necessary to

adjust net income that is determined using the accrual method to a cash ﬂowamount. Increases in current assets and decreases in current liabilities are
positive adjustments to arrive at the cash ﬂow; decreases in current assets
and increases in current liabilities are negative adjustments to arrive at thecash ﬂow.
Cash ﬂow for/from investing is the cash ﬂows related to the acquisition

(purchase) of plant, equipment, and other assets, as well as the proceedsfrom the sale of assets. Cash ﬂow for/from ﬁnancing activities is the cash
ﬂow from activities related to the sources of capital funds (e.g., buybackcommon stock, pay dividends, issue bonds). For the ABC Company, theseare fairly straightforward.
Not all of the classiﬁcations required by accounting principles are con-
sistent with the true ﬂow for the three types of activities. For example,

interest expense is a ﬁnancing cash ﬂow, yet it affects the cash ﬂow from
operating activities because it is a deduction to arrive at net income. Thisinconsistency is also the case for interest income and dividend income, both
of which result from investing activities, but show up in the cash ﬂow from
operating activities through their contribution to net income.
The sources of a company’s cash ﬂows can reveal a great deal about

the company and its prospects. For example, a ﬁnancially healthy companytends to consistently generate cash ﬂows from operations (that is, positiveoperating cash ﬂows) and invests cash ﬂows (that is, negative investing
cash ﬂows). To remain viable, a company must be able to generate funds
from its operations; to grow, a company must continually make capitalinvestments.
The change in cash ﬂow—also called net cash ﬂow—is the bottom line

in the statement of cash ﬂows and is equal to the change in the cash ac-count as reported on the balance sheet. For the ABC Company, shown in
Exhibit 4.6, the net change in cash ﬂow is a −$50 million; this is equal to
the change in the cash account from $100 million in 2008 to $50 million
in 2009.
By studying the cash ﬂows of a company over time, we can gauge a
company’s ﬁnancial health. For example, if a company relies on external

ﬁnancing to support its operations (that is, reliant on cash ﬂows from ﬁ-
nancing and not from operations) for an extended period of time, this is awarning sign of ﬁnancial trouble up ahead.

Financial Statements 81
TRY IT! CASH FLOW FROM OPERATIONS
Suppose a company has net income of $1 million and depreciation of
$0.2 million. If the company’s inventory decreased by $0.3 million and
accounts receivable increased by $0.4 million, what is this company’s
cash ﬂow from operations?
The Statement of Stockholders’ Equity

Thestatement of stockholders’ equity (also referred to as the statement of
shareholders’ equity) is a summary of the changes in the equity accounts,
including information on stock options exercised, repurchases of shares,
and Treasury shares. The basic structure is to include a reconciliation of
the balance in each component of equity from the beginning of the ﬁscal

year with the end of the ﬁscal year, detailing changes attributed to netincome, dividends, purchases or sales of Treasury stock. The components are
common stock, additional paid-in capital, retained earnings, and Treasury
stock. For each of these components, the statement begins with the balanceof each at the end of the previous ﬁscal period and then adjustments are
shown to produce the balance at the end of the current ﬁscal period.

In addition, there is a reconciliation of any gains or losses that affect
stockholders’ equity but which do not ﬂow through the income statement,such as foreign-currency translation adjustments and unrealized gains on
investments. These items are of interest because they are part of comprehen-sive income, and hence income to owners, but they are not represented on
the company’s income statement.
HOW ARE THE STATEMENTS RELATED?

The four basic statements are the result of transactions that record each
activity of the company. As a result, the ﬁnancial statements are inter-related.
For example,
■The change in cash, the bottom line of the statement cash ﬂows, is equal
to the change in the cash balance from the previous ﬁscal period to the
current ﬁscal period.

82 FINANCIAL MANAGEMENT
■Net income, the bottom line of the income statement, is the starting point
of the statement of cash ﬂows, and contributes to retained earnings inthe balance sheet and the statement of shareholders’ equity.

■The changes in the working capital accounts are adjustments to thearrive at the cash ﬂow from operating activities in the statement of cashﬂows, the changes in the asset accounts contribute to changes in cash
ﬂows from investing activities, and debt issuances and repayments, as
well as issuance or repurchase of stock contribute to the change in cashﬂows for ﬁnancing activities.
WHY BOTHER ABOUT THE FOOTNOTES?

Footnotes to the ﬁnancial statements contain additional information, sup-plementing or explaining ﬁnancial statement data. These notes are presentedin both the annual report and the 10-K ﬁling (with the SEC), though the
latter usually provides a greater depth of information.
The footnotes to the ﬁnancial statements provide information pertain-
ing to:
■The signiﬁcant accounting policies and practices that the company

uses. This helps the analyst with the interpretation of the results,
comparability of the results to other companies and to other years
for the same company, and in assessing the quality of the reported
information.
■Income taxes. The footnotes tell us about the company’s current and
deferred income taxes, breakdowns by the type of tax (e.g., federalversus state), and the effective tax rate that the company is paying.
■Pension plans and other retirement programs. The detail about pension

plans, including the pension assets and the pension liability, is importantin determining whether a company’s pension plan is overfunded or
underfunded.
■Leases. You can learn about both the capital leases, which are the long-
term lease obligations that are reported on the balance sheet, and aboutthe future commitments under operating leases, which are not reﬂected
on the balance sheet.
■Long-term debt. You can ﬁnd detailed information about the maturity

dates and interest rates on the company’s debt obligations.
■Stock-based compensation. You can ﬁnd detailed information about
stock options granted to ofﬁcers and employees. This footnote also
includes company’s accounting method for stock-based compensation
and the impact of the method on the reported results.

Financial Statements 83
■Derivative instruments. This describes accounting policies for cer-
tain derivative instruments (ﬁnancial and commodity derivative instru-
ments), as well as the types of derivative instruments.
The phrase “the devil is in the details” applies aptly to the footnotes
of a company’s ﬁnancial statement. Through the footnotes, a company is

providing information that is crucial in analyzing a company’s ﬁnancial
health and performance. If footnotes are vague or confusing, as they werein the case of Enron prior to the break in the scandal, the analyst must ask
questions to help understand this information.
ACCOUNTING FLEXIBILITY
The generally accepted accounting principles provide some choices in themanner in which some transactions and assets are accounted. For example,

a company may choose to account for inventory, and hence costs of sales,using Last-in, First-out (LIFO) or First-in, First-out (FIFO). With LIFO,
the most recent costs of items inventory are used to determine cost of goodssold, whereas with FIFO the oldest costs are used. This is intentional becausethese principles are applied to a broad set of companies and no single set of
methods offers the best representation of a company’s condition or perfor-

mance for all companies. Ideally, a company’s management, in consultationwith the accountants, chooses those accounting methods and presentations
that are most appropriate for the company.
A company’s management has always had the ability to manage earnings
through the judicious choice of accounting methods within the GAAP frame-
work. The company’s “watchdogs” (i.e., the accountants) should keep thecompany’s management in check. However, recent scandals have revealed

that the watchdog function of the accounting companies was not work-
ing well. Additionally, some companies’ management used manipulation ofﬁnancial results and outright fraud to distort the ﬁnancial picture.
The Sarbanes-Oxley Act of 2002 offers some comfort in terms of cre-
ating the oversight board for the auditing accounting companies. In addi-tion, the Securities and Exchange Commission, the Financial Accounting
Standards Board, and the International Accounting Standards Board are

tightening some of the ﬂexibility that companies had in the past.
U.S. ACCOUNTING VS. OUTSIDE OF THE U.S.
The generally accepted accounting standards in the United States (U.S.GAAP) differ from those used in other countries around the world. But

84 FINANCIAL MANAGEMENT
not for long. What is happening is an international convergence of account-
ing standards. The ﬁrst major step was the agreement in 2002 between twomajor standard setting bodies—the U.S.’s Financial Accounting Standards
Board (FASB) and the International Accounting Standards Board (IASB)—to

work together for eventual convergence of accounting principles. The sec-ond major step was the requirement of International Financial Reporting
Standards (IFRS) by the European Commission, effective in 2005. The third
major step is the voluntary application of IFRS by U.S. domiciled companiesfor ﬁscal years ending after December 15, 2009.
6
IFRS are promulgated by the IASB and must be used by all pub-

licly traded and private companies in the European Union. IFRS are alsoused, in varying degrees, by companies in Australia, Hong Kong, Russia,
and China.
There are more similarities than differences between IFRS and U.S.
GAAP. IFRS, like GAAP, uses historical cost as the main accounting conven-
tion. However, IFRS permits the revaluation of intangible assets, property,plant, and equipment, and investment property. IFRS also requires fair val-

uation of certain categories of ﬁnancial instruments and certain biological
assets. U.S. GAAP, on the other hand, prohibits revaluations except for cer-tain categories of ﬁnancial instruments, which must be carried at fair value,
and goodwill, which is tested each year for impairment (that is, a loss of
value).
Because there has been a long “road map” to convergence, and be-

cause many of the accounting principles issued in the past few years havebeen issued jointly by FASB and IASB, convergence, when it happens,should not result in a dramatic change in the ﬁnancial statements of U.S.
companies.
■Financial statements provide information about a company’s operatingperformance, as well as its ﬁnancial condition. These statements are
prepared according to generally accepted accounting principles.

■The assumptions in preparing ﬁnancial statements are that (1) transac-
tions are recorded at historical cost, (2) the appropriate unit of measure-
ment is the dollar, (3) statements are recorded for predeﬁned periods
6The current “roadmap” to convergence has a 2014 target for mandatory application
of IFRS to U.S. companies.

Financial Statements 85
of time, (4) statements are prepared using accrual accounting and the
matching principle, (5) the business will continue as a going concern,(6) there is full disclosure, and (7) if more than one interpretation of an
event is possible, statements are prepared using the most conservative
interpretation.

■The basic statements are the balance sheet, the income statement,
the statement of cash ﬂows, and the statement of shareholders’
equity.
■There is some ﬂexibility built into accounting principles, so it is impor-
tant to understand just how much ﬂexibility there is and how choices
a company make affect the reported ﬁnancial statements. For example,companies can choose among a number of methods for depreciation for

ﬁnancial reporting purposes, though the MACRS system is used for tax
purposes.
■The footnotes to the ﬁnancial statements provide information pertainingto (1) signiﬁcant accounting policies and practices that the companyuses, (2) income taxes, (3) pension plans and other retirement programs,
(4) leases, (5) long-term debt, (6) stock-based compensation granted to
ofﬁcers and (7) derivative instruments.
SOLUTIONS TO TRY IT! PROBLEMS
MACRS Depreciation
Year Rate MACRS Depreciation

1 33.33% $ 6,666.672 44.44% $ 8,888.89
3 14.81% $ 2,962.96
4 7.41% $ 1,481.48
Sum $20,000.00
Cash Flow from Operations
Net income $1.0
Plus depreciation $0.2
Plus decrease in inventory $0.3
Less increase in accounts receivable −$0.4
Cash ﬂow from operations $1.1

86 FINANCIAL MANAGEMENT
QUESTIONS
1.What is the accounting identity?
2.List at least three of the assumptions underlying ﬁnancial statements.
3.Identify at least three current asset accounts.
4.What is the operating cycle?
5.Identify three current liability accounts.
6.What are retained earnings?
7.Is the minority interest account on the balance sheet a liability, equity,
or neither?

8.What is the difference between basic earnings per share and dilutedearnings per share?
9.If an asset is depreciated for tax purposes using MACRS, but depreciated
using straight-line depreciation for ﬁnancial reporting purposes, how are
deferred tax liabilities created?
10.What is the sum of the cash ﬂows from operating activities, ﬁnancingactivities, and investing activities?
11.What does it mean that the ﬁnancial statements are prepared based on
historical cost?

12.Where can an investor ﬁnd out more about deferred taxes reported in
the balance sheet?
13.What follows is information from the balance sheet (in millions ofdollars) for Microsoft Corporation for its 2009 ﬁscal year (ending June30, 2009) with certain information intentionally deleted.
Assets Liabilities and Stockholders’ Equity
Cash and cash
equivalents
Short-term investments
Accounts receivable
Inventories
Deferred income taxes,
current portion

Other current assetsNet property and
equipment
Equity and other
investments
Goodwill
Intangible assets, net
Deferred income taxesOther long-term assets$ 6,076
25,37111,192
717
2,213
3,711
7,535
4,933
12,503
1,759
279
1,599Accounts payable
Short-term debt
Accrued compensationIncome taxes
Short-term unearned revenue
Securities lending payableOther
Long-term debt
Long-term unearned revenueOther long-term liabilities
Stockholders’ equity:

Common stock and paid-in
capital—shares authorized
24,000; outstanding 8,908
Retained deﬁcit, including
accumulated othercomprehensive income of
$969$ 3,324
2,0003,156
725
13,003
1,6843,142
3,746
1,2816,269
62,382
(22,824)

Financial Statements 87
Compute each of the following based on Microsoft Corporation’s bal-
ance sheet:a.Total current assets
b.Total assets
c.Total liabilities
d.Stockholders’ equity
e.Total liabilities plus stockholders’ equity
14.The following is a table showing the calculation of earnings per share asit appears in the 2009 ﬁnancial statements of Microsoft Corporation.

In millions, except earnings per share
Year Ended June 30, 2009 2008 2007
Net income available for common shareholders (A) $14,569 $17,681 $14,065
Weighted average outstanding shares of common
stock (B)8,945 9,328 9,742
Dilutive effect of stock-based awards 51 142 144
Common stock and common stock equivalents (C) 8,996 9,470 9,886
Earnings per share:
Basic (A/B) $1.63 $1.90 $1.44
Diluted (A/C) $1.62 $1.87 $1.42
a.Why are there two earnings per share numbers reported?

b.What does “Basic” mean under “Earnings per share”?
c.What does “Diluted” mean under “Earnings per share”?
d.For all three ﬁscal years, both earnings per share measures in a given
ﬁscal year are close in value. What does that suggest?
15.The following excerpt is taken from a publication of the American
Institute of Certiﬁed Public Accountants (we won’t give the title since it
is the answer to one of the questions):
Great strides have been made by the FASB and the IASB to

converge the content of IFRS and U.S. GAAP. The goal is that
by the time the SEC allows or mandates the use of IFRS for U.S.publicly-traded companies, most or all of the key differences
will have been resolved.
Because of these ongoing convergence projects, the extent
of the speciﬁc differences between IFRS and U.S. GAAP is
shrinking. Yet signiﬁcant differences do remain. For exampleIFRS does not permit Last In First Out (LIFO) as an inventory
costing method.
a.What is the FASB?

b.What is the IFRS?
c.What is meant by GAAP?

88

c05 JWBT310-Fabozzi July 1, 2010 15:15 Printer: Courier Westford, Westford, MA
CHAPTER5
Business Finance
Corporate governance is about maintaining an appropriate
balance of accountability between three key players: the
corporation’s owners, the directors whom the owners elect, and
the managers whom the directors select. Accountability requiresnot only good transparency, but also an effective means to take
action for poor performance or bad decisions.

—Chairman Mary L. Schapiro, U.S. Securities and Exchange
Commission, September 17, 2009
Financial management encompasses many different types of decisions. Wecan classify these decisions into three groups: investment decisions, ﬁ-
nancing decisions, and decisions that involve both investing and ﬁnancing.
Investment decisions are concerned with the use of funds—the buying, hold-
ing, or selling of all types of assets: Should we buy a new die stamping

machine? Should we introduce a new product line? Sell the old productionfacility? Buy an existing company? Build a warehouse? Keep our cash in
the bank?
Financing decisions are concerned with the acquisition of funds to be
used for investing and ﬁnancing day-to-day operations. Should managementuse the money raised through the companies’ revenues? Should management

seek funds from outside of the business? A company’s operations and invest-ment can be ﬁnanced from outside the business by incurring debts, such as
through bank loans and the sale of bonds, or by selling ownership interests.
Because each method of ﬁnancing obligates the business in different ways,ﬁnancing decisions are very important.
Many business decisions simultaneously involve both investing and ﬁ-
nancing decisions. For example, a company may wish to acquire another

company—an investment decision. However, the success of the acquisition
89

90 FINANCIAL MANAGEMENT
may depend on how it is ﬁnanced: by borrowing cash to meet the purchase
price, by selling additional shares of stock, or by exchanging its shares ofstock for the stock or assets of the company it is seeking to acquire. If
management decides to borrow money, the borrowed funds must be repaid

within a speciﬁed period of time. Creditors (those lending the money) gener-ally do not share in the control of proﬁts of the borrowing company. If, on
the other hand, management decides to raise funds by selling ownership in-
terests, these funds never have to be paid back. However, such a sale dilutesthe control of (and proﬁts accruing to) the current owners.
In this chapter, we provide an overview of ﬁnancial management: the

forms of business enterprise, the objectives of ﬁnancial management, andthe relationship between ﬁnancial managers and shareholders and other
stakeholders.
FORMS OF BUSINESS ENTERPRISE
Financial management is not restricted to large corporations: It is necessary
in all forms and sizes of businesses. The three major forms of business orga-
nization are the sole proprietorship, the partnership, and the corporation.
These forms differ in a number of factors, of which those most important

to ﬁnancial decision-making are:
■Taxation
■Degree of control
■Owners’ liability
■Ease of transferring ownership.
■Ability to raise additional funds.
■Longevity of the business.
We summarize the advantages and disadvantages of the major forms of
business from the point of view of ﬁnancial decision-making in Exhibit 5.1.
Sole Proprietorships and Partnerships
A sole proprietorship is a business entity owned by one party, and is the
simplest of the forms of business:
■It is easy to form.

■The business income is taxed along with the owner’s other income.
■The owner is liable for the debts of the business.
■The owner controls the decisions of the business.
■The business ends when the owner does.

Business Finance 91
EXHIBIT 5.1 Characteristics of the Basic Forms of Business
Advantages Disadvantages
1. The proprietor is the sole business
decision-maker.
2. The proprietor receives all income
from the business.
3. Income from the business is taxed
once, at the individual taxpayer
level.1. The proprietor is liable for all
debts of the business (unlimited
liability).

2. The proprietorship has a limited
life.
3. There is limited access to
additional funds.Sole Proprietorship
1. Partners receive income according
to terms in partnership agreement.
2. Income from business is taxed
once as the partners’ personal
income.
3. Decision-making rests with the
general partners only.1. Each partner is liable for all the
debts of the partnership.
2. The partnership’s life is
determined by agreement or thelife of the partners.

additional funds.Partnership
1. Each partner is liable for all the
additional funds.1. Income paid to owners is
subjected to double taxation.
2. Ownership and management are
separated in larger organizations.Corporation
The sole proprietorship is often the starting point for a small, ﬂedgling

business. But a sole proprietorship is often limited in its access to funds
beyond bank loans. Another form of business that offers additional sources
of funds is the partnership.
Apartnership is an agreement between two or more persons to operate
a business. A partnership is similar to a sole proprietorship except instead
of one proprietor, there is more than one. The fact that there is more thanone proprietor introduces some issues: Who has a say in the day-to-day

operations of the business? Who is liable (that is, ﬁnancially responsible) for
the debts of the business? How is the income distributed among the owners?How is the income taxed? Some of these issues are resolved with the part-
nership agreement; others are resolved by laws. The partnership agreement
describes how proﬁts and losses are to be shared among the partners, and itdetails their responsibilities in the management of the business.

Most partnerships are general partnerships, consisting only of general
partners who participate fully in the management of the business, share in its

92 FINANCIAL MANAGEMENT
proﬁts and losses, and are responsible for its liabilities. Each general partner
is personally and individually liable for the debts of the business, even ifthose debts were contracted by other partners.
Alimited partnership consists of at least one general partner and one
limited partner . Limited partners invest in the business, but do not partici-

pate in its management. A limited partner’s share in the proﬁts and losses of
the business is limited by the partnership agreement. In addition, a limited
partner is not liable for the debts incurred by the business beyond his or herinitial investment.
A partnership is not taxed as a separate entity. Instead, each partner
reports his or her share of the business proﬁt or loss on his or her personalincome tax return. Each partner’s share is taxed as if it were from a sole
proprietorship.

The life of a partnership may be limited by the partnership agreement.
For example, the partners may agree that the partnership is to exist only
for a speciﬁed number of years or only for the duration of a speciﬁc busi-ness transaction. The partnership must be terminated when any one of the
partners dies, no matter what is speciﬁed in the partnership agreement. Part-

nership interests cannot be passed to heirs; at the death of any partner, thepartnership is dissolved and perhaps renegotiated.
One of the drawbacks of partnerships is that a partner’s interest in
the business cannot be sold without the consent of the other partners. So apartner who needs to sell his or her interest because of, say, personal ﬁnancial
needs may not be able to do so. Still another problem involves ending a

partnership and settling up, mainly because it is difﬁcult to determine thevalue of the partnership and of each partner’s share.
Another drawback is the partnership’s limited access to new funds. Short
of selling part of their own ownership interest, the partners can raise moneyonly by borrowing from banks—and here too there is a limit to what a bank
will lend a (usually small) partnership.
Corporations
Acorporation is a legal entity created under state laws through the process

of incorporation. The corporation is an organization capable of entering
into contracts and carrying out business under its own name, separate fromit owners. To become a corporation, state laws generally require that a
company must do the following: (1) ﬁle articles of incorporation, (2) adopt
a set of bylaws, and (3) form a board of directors.
Thearticles of incorporation specify the legal name of the corporation,
its place of business, and the nature of its business. This certiﬁcate gives

Business Finance 93
“life” to a corporation in the sense that it represents a contract between
the corporation and its owners. This contract authorizes the corporation toissue units of ownership, called shares, and speciﬁes the rights of the owners,
theshareholders.
Thebylaws are the rules of governance for the corporation. The bylaws

deﬁne the rights and obligations of ofﬁcers, members of the board of direc-
tors, and shareholders. In most large corporations, it is not possible for each
owner to participate in monitoring the management of the business. There-fore, the owners of a corporation elect a board of directors to represent them
in the major business decisions and to monitor the activities of the corpora-

tion’s management. The board of directors, in turn, appoints and overseesthe ofﬁcers of the corporation. Directors who are also employees of the
corporation are called insider directors ; those who have no other position
within the corporation are outside directors orindependent directors.
The state recognizes the existence of the corporation in the corporate
charter. Once created, the corporation can enter into contracts, adopt a legal

name, sue or be sued, and continue in existence forever. Though owners may
die, the corporation continues to live. The liability of owners is limited to
the amounts they have invested in the corporation through the shares ofownership they purchased. The corporation is a taxable entity. It ﬁles its
own income tax return and pays taxes on its income.
If the board of directors decides to distribute cash to the owners, that

money is paid out of income left over after the corporate income tax hasbeen paid. The amount of that cash payment, or dividend ,m u s ta l s ob e
included in the taxable income of the owners (the shareholders). Therefore,
a portion of the corporation’s income (the portion paid out to owners)
is subject to double taxation: once as corporate income and once as the
individual owner’s income.
The ownership of a corporation, also referred to as stock or equity, is

represented as shares of stock. A corporation that has just a few ownerswho exert complete control over the decisions of the corporation is referred
to as a closely held corporation or aclose corporation.
A corporation whose ownership shares are sold outside of a closed
group of owners is referred to as a publicly held corporation or a public
corporation. Mars Inc., producer of M&M candies and other confectionery

products, is a closely held corporation; Hershey Foods, also a producer ofcandy products among other things, is a publicly held corporation.
The shares of public corporations are freely traded in securities mar-
kets, such as the New York Stock Exchange. Hence, the ownership of apublicly held corporation is more easily transferred than the ownership of a
proprietorship, a partnership, or a closely held corporation.

94 FINANCIAL MANAGEMENT
HOW IS INCOME DOUBLE TAXED?
Consider a corporation with $100 million of taxable income. Let’s
assume a simple tax system with a ﬂat corporate tax rate is 35%. The
corporation pays $35 million in taxes, and therefore has $65 million
in earnings after taxes.
Now suppose that same corporation pays all of its earnings to its

shareholders in the form of a cash dividend. Let’s assume a simple taxsystem with a ﬂat individual tax rate of 30%. Therefore, the tax theowners pay is:
Individual income tax =0.3×$65 million
=$19.5 million
The total tax paid on this company’s income is, effectively $35 +
$19.5 million =$54.4 million. Therefore, every dollar of income of
the corporation is taxed at the rate of =$54.5 million ÷$100 million
=54.4%.
Companies whose stock is traded in public markets are required to ﬁle an

initial registration statement with the Securities and Exchange Commission,
a federal agency created to oversee the enforcement of U.S. securities laws.
The statement provides ﬁnancial statements, articles of incorporation, anddescriptive information regarding the nature of the business, the debt and
stock of the corporation, the ofﬁcers and directors, and any individuals who
own more than 10% of the stock, among other items.
TRY IT! EFFECTIVE TAX RATE

Consider a company that generates $2 million in taxable income for a
year. If the corporate tax rate is 38% and the individual shareholders’
tax rate is 40%, what is the effective tax rate on the corporation’sincome if all of the corporation’s income after tax is distributed to
owners in the form of dividends?
The Limited Liability Company
A popular form of business, especially with small businesses, is the hybrid

form of business, the limited liability company (LLC) or a limited liability

Business Finance 95
partnership (LLP), which combine the best features of a partnership and a
corporation. In 1988, the Internal Revenue Service (IRS) ruled that the LLC
may be treated as a partnership for tax purposes, while retaining its limitedliability for its owners. Since this ruling, every state has passed legislation
permitting limited liability companies.

The LLC differs slightly from the LLP, because in the latter the partners
may be liable for some, but not all, of the debts of the business. However,the distinction is subtle and most rules that apply to an LLC apply to an LLP
as well. Though state laws vary slightly, in general, the owners of LLCs havelimited liability. Therefore, the LLC and LLP forms represents a hybrid, with
the best of both partnerships and corporations.

The owners of an LLC are referred to as members, and these owners
may be individuals, partnerships, corporations, or other entities. Thoughthere are few restrictions to who may form an LLC, banks and insurance
companies are not permitted to operate as LLCs. Some types of companiesthat are prohibited from doing business as a corporation may be permitted
to form an LLC. For example, accounting companies may operate as an

LLC or an LLP, but cannot operate as a corporation.
The LLC is not considered a form of business for tax purposes, so a
company formed as an LLC must ﬁle as a corporation, a partnership, ora sole proprietorship. In general, a LLP must ﬁle as a partnership. The
IRS considers the LLC to be taxed as a partnership if the company has
no more than two of the following characteristics: (1) limited liability,(2) centralized management, (3) free transferability of ownership interests,

and (4) continuity of life. If the company has more than two of these, it
will be treated as a corporation for tax purposes, subjecting the income totaxation at both the company level and the owners’.
A drawback of an LLC for tax purposes is that if the LLC has a net
operating loss, the amount of the loss that is deductible for tax purposes islimited because the owners’ liability is limited.
Other Forms of Business
In addition to the proprietorship, partnership, and corporate forms of busi-

ness, an enterprise may be conducted using other forms of business, such as
the master limited partnership, the professional corporation, and the jointventure.
Amaster limited partnership (MLP) is a partnership with limited partner
ownership interests that are traded on an organized exchange. For example,more than two dozen master limited partnerships are listed on the New York
Stock Exchange, including the Cedar Fair, Global Partners, and Sunoco

Logistics Partners partnerships. Many of these MLPs operate in the oil and

96 FINANCIAL MANAGEMENT
gas industry. Ownership interests, which represent a speciﬁed ownership
percentage, are traded in much the same way as the shares of stock ofa corporation. One difference, however, is that a corporation can raise
new capital by issuing new ownership interests, whereas a master limited

partnership cannot because it is not possible to sell more than a 100%interest in the partnership, yet it is possible to sell additional shares of stock
in a corporation. Another difference is that the income of a master limited
partnership is taxed only once, as partners’ individual income.
Another variant of the corporate form of business is the professional
corporation. A professional corporation is an organization that is formed

under state law and treated as a corporation for federal tax law purposes,yet that has unlimited liability for its owners—the owners are personally
liable for the debts of the corporation. Businesses that are likely to form
such corporations are those that provide services and require state licensing,
such as physicians’, architects’, and attorneys’ practices since it is generally
felt that it is in the public interest to hold such professionals responsible forthe liabilities of the business.

Ajoint venture , which may be structured as either a partnership or as
a corporation, is a business undertaken by a group of persons or entities(such as a partnership or corporation) for a speciﬁc business activity and,
therefore, does not constitute a continuing relationship among the parties.
For tax and other legal purposes, a joint venture partnership is treated as apartnership and a joint venture corporation is treated as a corporation.

U.S. corporations have entered into joint ventures with foreign corpo-
rations, enhancing participation and competition in the global marketplace.Joint ventures are becoming increasingly popular as a way of doing busi-
ness. Participants—whether individuals, partnerships, or corporations—get
together to exploit a speciﬁc business opportunity. Afterward, the venturecan be dissolved. Recent alliances among communication and entertainment

companies have sparked thought about what the future form of doing busi-
ness will be. Some believe that what lies ahead is a virtual enterprise—a tem-
porary alliance without all the bureaucracy of the typical corporation—that
can move quickly and decisively to take advantage of proﬁtable businessopportunities.
Prevalence

The number of sole proprietorships in the U.S. is signiﬁcantly larger thanthat of partnerships and corporations, as you can see in Exhibit 5.2 for theU.S. based on 2006 tax returns. However, the net income of corporations,
which typically are larger ﬁrms than partnerships and sole proprietorships,
comprises the larger portion of taxable income in the U.S.

Business Finance 97
EXHIBIT 5.2 Prevalence of Forms of Business, Based on Tax Returns Filed
in 2006
Source of data: Statistics of Income, Internal Revenue Service.
THE OBJECTIVE OF FINANCIAL MANAGEMENT
So far we have seen that ﬁnancial managers are primarily concerned with
investment decisions and ﬁnancing decisions within business organizations.

The great majority of these decisions are made within the corporate businessstructure, which better accommodates growth and is responsible for over
67% of U.S. business net income.
One such issue concerns the objective of ﬁnancial decision-making.
What goal (or goals) do managers have in mind when they choose between ﬁ-nancial alternatives—say, between distributing current income among share-
holders and investing it to increase future income? There is actually one ﬁ-

nancial objective: the maximization of the economic well-being, or wealth, of
the owners. Whenever a decision is to be made, management should choosethe alternative that most increases the wealth of the owners of the business.
A Measure of Owners’ Economic Well-Being
The price of a share of stock at any time, or its market value , represents the
price that buyers in a free market are willing to pay for it. The market value

of shareholders’ equity is the value of all owners’ interest in the corporation.
This market value is also referred to as the stock’s market capitalization ,o r
simply its market cap. It is calculated as the product of the market value of
one share of stock and the number of shares of stock outstanding:
Market value of shareholders’ equity =Market price per share of stock
×Number of shares outstanding

98 FINANCIAL MANAGEMENT
The number of shares of stock outstanding is the total number of shares
that are owned by shareholders. For example, on December 24, 2009, there
were 3.81 billion Wal-Mart common shares outstanding. The price per
share at the closing on that date was $53.50. Therefore, the market value of
Wal-Mart’s common stock is 3.81 billion ×$53.60 =$204.216 billion.

Investors buy shares of stock in anticipation of future dividends and
increases in the market value of the stock. How much are they willing topay today for this future—and hence uncertain—stream of dividends? Theyare willing to pay exactly what they believe it is worth today, an amount
that is called the present value, an important ﬁnancial concept that we
discuss in Chapter 10. The present value of a share of stock reﬂects the
following factors:

■The uncertainty associated with receiving future payments.
■The timing of these future payments.
■Compensation for tying up funds in this investment.
The market price of a share is a measure of owners’ economic well-being.
Does this mean that if the share price goes up, management is doing a good
job? Not necessarily. Share prices often can be inﬂuenced by factors beyondthe control of management. These factors include expectations regarding

the economy, returns available on alternative investments (such as bonds),
and even how investors view the company and the idea of investing.
These factors inﬂuence the price of shares through their effects on ex-
pectations regarding future cash ﬂows and investors’ evaluation of thosecash ﬂows. Nonetheless, managers can still maximize the value of owners’equity, given current economic conditions and expectations. They do so by

carefully considering the expected beneﬁts, risk, and timing of the returns
on proposed investments.
TRY IT! MARKET CAPITALIZATION
The following data is available for a company at a speciﬁc point intime:
Average daily volume of shares traded 11.5 million
Book value per share $18.27
Market price per share $64.70
Number of shares outstanding 2.76 billion
What is the market capitalization of this company?

Business Finance 99
Financial Management and the Maximization of Owners’ Wealth Finan-
cial managers are charged with the responsibility of making decisions that
maximize owners’ wealth. For a corporation, that responsibility translates
into maximizing the value of shareholders’ equity. If the market for stocks

is efﬁcient, the value of a share of stock in a corporation should reﬂectinvestors’ expectations regarding the future prospects of the corporation.
The value of a stock will change as investors’ expectations about the future
change. For ﬁnancial managers’ decisions to add value, the present value
of the beneﬁts resulting from decisions must outweigh the associated costs,
where costs include the costs of capital.
If there is a separation of the ownership and management of a

company—that is, the owners are not also the managers of the company—there are additional issues to confront. What if a decision is in the best in-terests of the company, but not in the best interest of the manager? How
can owners ensure that managers are watching out for the owners’ interests?
How can owners motivate managers to make decisions that are best for theowners? We address these issues and more in the next section.
The Agency Relationship

If you are the sole owner of a business, you make the decisions that affect
your own well-being. But what if you are a ﬁnancial manager of a business
and you are not the sole owner? In this case, you are making decisions for
owners other than yourself; you, the ﬁnancial manager, are an agent. An
agent is a person who acts for—and exerts powers of—another person or
group of persons. The person (or group of persons) the agent represents

is referred to as the principal . The relationship between the agent and his
or her principal is an agency relationship. There is an agency relationship
between the managers and the shareholders of corporations.1
Problems with the Agency Relationship In an agency relationship, the
agent is charged with the responsibility of acting for the principal. Is it
possible the agent may not act in the best interest of the principal, but

instead act in his or her own self-interest? Yes—because the agent has his or
her own objective of maximizing personal wealth.
In a large corporation, for example, the managers may enjoy many fringe
beneﬁts, such as golf club memberships, access to private jets, and company
1The agency relationship was ﬁrst described in Michael C. Jensen and William H.
Meckling, “Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership
Structure,” Journal of Financial Economics 3(1976): 305–360.

100 FINANCIAL MANAGEMENT
cars. These beneﬁts (also called perquisites orperks) may be useful in con-
ducting business and may help attract or retain management personnel, but
there is room for abuse. What if the managers start spending more time atthe golf course than at their desks? What if they use the company jets for

personal travel? What if they buy company cars for their teenagers to drive?
The abuse of perquisites imposes costs on the company—and ultimately onthe owners of the company. There is also a possibility that managers who
feel secure in their positions may not bother to expend their best efforts
toward the business. This is referred to as shirking , and it too imposes a cost
to the company.
Finally, there is the possibility that managers will act in their own self-

interest, rather than in the interest of the shareholders when those interestsclash. For example, management may ﬁght the acquisition of their com-
pany by some other company, even if the acquisition would beneﬁt share-
holders. Why? In most takeovers, the management personnel of the acquiredcompany generally lose their jobs. Envision that some company is making
an offer to acquire the company that you manage. Are you happy that the

acquiring company is offering the shareholders of your company more for
their stock than its current market value? If you are looking out for their
best interests, you should be. Are you happy about the likely prospect oflosing your job? Most likely not.
Defensiveness by corporate managers in the case of takeovers, whether
warranted or not, emphasizes the potential for conﬂict between the inter-ests of the owners and the interests of management.
2Defending against a

takeover that would not produce a beneﬁt for the shareholders is consistentwith management’s obligations. However, defending against a takeover thatwould produce a beneﬁt for shareholders, but also a detriment to manage-
ment (e.g., lost jobs), would be contrary to management’s duty to share-
holders.
Costs of the Agency Relationship There are costs involved with any effort
to minimize the potential for conﬂict between the principal’s interest and

the agent’s interest. Such costs are called agency costs, and they are of three
types: monitoring costs, bonding costs, and residual loss.
Monitoring costs are costs incurred by the principal to monitor or
limit the actions of the agent. In a corporation, shareholders may require
2There was abuse by some companies during the merger mania of the 1980s. Some
fought acquisition of their companies—which they labeled hostile takeovers—by

proposing changes in the corporate charter or even lobbying for changes in state
laws to discourage takeovers. Some adopted lucrative executive compensationpackages—called golden parachutes —that were to go into effect if they lost their
jobs.

Business Finance 101
managers to periodically report on their activities via audited accounting
statements, which are sent to shareholders. The fees for auditing and prepar-ing the ﬁnancial statements and the management time lost in preparing such
statements are monitoring costs. Another example is the implicit cost in-

curred when shareholders limit the decision-making power of managers.By doing so, the owners may miss proﬁtable investment opportunities; the
foregone proﬁt is a monitoring cost.
The board of directors of a corporation has a ﬁduciary duty to share-
holders; that is the legal responsibility to make decisions (or to see thatdecisions are made) that are in the best interests of shareholders. Part of

that responsibility is to ensure that managerial decisions are also in the bestinterests of the shareholders. Therefore, at least part of the cost of having
directors is a monitoring cost.
Bonding costs are incurred by agents to assure principals that they will
act in the principal’s best interest. The name comes from the agent’s promise
or bond to take certain actions. A manager may enter into a contract thatrequires him or her to stay on with the company even though another

company acquires it; an implicit cost is then incurred by the manager, who
foregoes other employment opportunities.
Even when monitoring and bonding devices are used, there may be
some divergence between the interests of principals and those of agents.The resulting cost, called the residual loss, is the implicit cost that results
because the principal’s and the agent’s interests cannot be perfectly aligned
even when monitoring and bonding costs are incurred.

Motivating Managers: Executive Compensation
One way to encourage management to act in shareholders’ best inter-
ests, and so minimize agency problems and costs, is through executivecompensation—how top management is paid. There are several different
ways to compensate executives, including:
■Salary. The direct payment of cash of a ﬁxed amount per period.
■Bonus . A cash reward based on some performance measure, say, earn-
ings of a division or the company.

■Stock appreciation right . A cash payment based on the amount by which
the value of a speciﬁed number of shares has increased over a speciﬁedperiod of time (supposedly due to the efforts of management).
■Performance shares. Shares of stock given the employees, in an amount
based on some measure of operating performance, such as earnings
per share.
■Stock option. The right to buy a speciﬁed number of shares of stock in

the company at a stated price—referred to as an exercise price at some

102 FINANCIAL MANAGEMENT
time in the future. The exercise price may be above, at, or below the
current market price of the stock.
■Restricted stock grant . The grant of shares of stock to the employee
at low or no cost, conditional on the shares not being sold for aspeciﬁed time.
The salary portion of the compensation—the minimum cash payment

an executive receives—must be enough to attract talented executives. But a
bonus should be based on some measure of performance that is in the best
interests of shareholders—not just on the past year’s accounting earnings.For example, a bonus could be based on gains in market share.
The basic idea behind stock options and restricted stock grants is to
make managers owners, since the incentive to consume excessive perks and

to shirk are reduced if managers are also owners. As owners, managers not
only share the costs of perks and shirks, but they also beneﬁt ﬁnancially whentheir decisions maximize the wealth of owners. Hence, the key to motivation
through stock is not really the value of the stock, but rather ownership of
the stock. For this reason, stock appreciation rights and performance shares,
which do not involve an investment on the part of the recipients, are not
effective motivators.

Stock options do work to motivate performance if they require owning
the shares over a long time period; are exercisable at a price signiﬁcantlyabove the current market price of the shares, thus encouraging managers to
get the share price up, and require managers to tie up their own wealth in
the shares. Unfortunately, executive stock option programs have not always
been designed in ways to sufﬁciently motivate executives.

Publicly-traded companies must disclose the compensation in a table, as
well as provide a discussion of key elements in the “Compensation Discus-sion and Analysis” portion of their SEC 10-K ﬁling and proxy statements.
3
The table provides the investor with information on the compensation thatis both cash-based and stock-based, with details on the options granted

and exercised by the top paid employees. This table enables the comparisonyear-to-year of each of the elements of a manager’s compensation.
Currently, there is a great deal of concern in some corporations because
executive compensation is not linked to performance. In recent years, manyU.S. companies have downsized, restructured, and laid off many employees
and allowed the wages of employees who survive the cuts to stagnate. At the

same time, corporations have increased the pay of top executives throughboth salary and lucrative stock options. If these changes lead to better value
3Rule 33-8732, August 11, 2006.

Business Finance 103
for shareholders, shouldn’t the top executives be rewarded? There are two
issues here. First, such a situation results in anger and disenchantment amongboth surviving employees and former employees. Second, the downsizing,
restructuring, and lay-offs may not result in immediate (or even, eventual)
increased proﬁtability.

Owners have one more tool with which to motivate management—the
threat of ﬁring. As long as owners can ﬁre managers, managers will beencouraged to act in the owners’ interest. However, if the owners are dividedor apathetic—as they might be in large corporations—or if they fail to
monitor management’s performance and the reaction of directors to that
performance, the threat may not be credible. The removal of a few poormanagers can, however, make this threat palpable.

Shareholder Wealth Maximization and Accounting “Irregularities”
There have been a number of scandals and allegations regarding the ﬁnancialinformation that is being reported to shareholders and the market. Finan-
cial results reported in the income statements and balance sheets of some
companies indicated much better performance than the true performance ormuch better ﬁnancial condition than actual. Examples include Xerox, which

was forced to restate earnings for several years because it had inﬂated pretax
proﬁts by $1.4 billion, Enron, which was accused of inﬂating earnings andhiding substantial debt, and Worldcom, which failed to properly account
for $3.8 billion of expenses.
However, some companies have also encountered problems when man-
agers understate earnings. For example, if a company’s earnings are notsufﬁcient to meet bonus targets, by understating income in one period—for

example, moving expenses forward in time or delaying recognition ofrevenues—there is a better possibility that the company will meet the bonus
targets in the following year.
Along with these ﬁnancial reporting issues, the independence of the au-
ditors and the role of ﬁnancial analysts have been brought to the forefront.
For example, the now-defunct public accounting company of Arthur An-dersen was found guilty of obstruction of justice in 2002 for their role in

the shredding of documents relating to Enron. As an example of the prob-
lems associated with ﬁnancial analysts, the securities company of MerrillLynch paid a $100 million ﬁne for their role in hyping stocks to help win
investment-banking business.
4
It is unclear at this time the extent to which these scandals and problems
were the result of simply bad decisions or due to corruption. The eagerness
4Merrill Lynch is now a part of Bank of America.

104 FINANCIAL MANAGEMENT
of managers to present favorable results to shareholders and the market
appears to be a factor in several instances. And personal enrichment at theexpense of shareholders seems to explain some cases. Whatever the moti-
vation, chief executive ofﬁcers (CEOs), chief ﬁnancial ofﬁcers (CFOs), and

board members are being held directly accountable for ﬁnancial disclosures.The Sarbanes-Oxley Act, passed in 2002, addresses these and other issues
pertaining to disclosures and governance in public corporations. This Act
addresses audits by independent public accountants, ﬁnancial reporting anddisclosures, conﬂicts of interest, and corporate governance at public compa-
nies. Each of the provisions of this Act can be traced to one or more scandals

that occurred in the few years leading up to the passage of the Act.
The accounting scandals created an awareness of the importance of
corporate governance, the importance of the independence of the publicaccounting auditing function, the role of ﬁnancial analysts, and the respon-
sibilities of CEOs and CFOs.
The recent economic crisis has again raised the issue of pay-for-

performance as companies receiving government bailouts are scrutinized fortheir executive pay practices. This suggests that more reform may be nec-
essary to insure transparency of ﬁnancial information and a better linkagebetween pay and performance.
Shareholder Wealth Maximization and Social Responsibility When ﬁnan-
cial managers assess a potential investment in a new product, they examine
the risks and the potential beneﬁts and costs. If the risk-adjusted beneﬁts

do not outweigh the costs, they will not invest. Similarly, managers assess
current investments for the same purpose; if beneﬁts do not continue tooutweigh costs, they will not continue to invest in the product but will
shift their investment elsewhere. This is consistent with the goal of share-
holder wealth maximization and with the efﬁcient allocation of resources inthe economy.
Discontinuing investment in an unproﬁtable business, however, may

mean effects on other stakeholders of the company: closing down plants,
laying off workers, affecting suppliers’ businesses, and, perhaps destroying
an entire town that depends on the business for income. So decisions toinvest or disinvest may affect great numbers of people.
■There are four primary forms of doing business: the sole proprietorship,the partnership, the corporation, and the limited liability company.

Business Finance 105
■The choice of the form of business affects the taxation of the com-
pany’s income, as well as the degree of control the owners have on thecompany’s decision-making.
■The objective of ﬁnancial management is to maximize owners’ wealth,which for a corporation means maximizing the value of the equity.
■When the management of the company is separated from the ownership

of the company, as in the case of large corporations, there are poten-
tial problems and costs associated with the relationship between thedecision-makers and the owners. The challenge is to devise a manage-
ment compensation structure that sufﬁciently motivates management to
act in owners’ best interest, and which minimizes agency costs.
Effective Tax Rate
Tax on corporate income =$2 million ×0.38=$0.76 million

Income to shareholders =$2 million −$0.76 million =$1.24 million
Tax on shareholders’ income =$1.24 ×0.40=$0.496 million
Effective tax rate =($0.76 million +$0.496 million) ÷$2 million =
62.8%
Market Capitalization
Market cap =2.76 billion shares ×$64.70 per share =$178.572 billion
QUESTIONS
1.What distinguishes a partnership from a corporation?
2.What is limited liability?
3.How does income get taxed twice in the case of a corporation?
4.Which forms of business have a perpetual life?

5.What are agency costs?
6.What is the objective of the ﬁnancial management of a company?
7.List three types of compensation for a company’s management.
8.How are options intended to align the interests of managers and owners
of a corporation?
9.If a manager signs a contract with a strict provision prohibiting the
manager from competing against this company if the manager leaves
the company, what type of agency cost is this provision?

106 FINANCIAL MANAGEMENT
11.What is meant by a company’s market capitalization?
12.The U.S. tax code allows the creation of a taxable entity known
as an S corporation. According to the Internal Revenue Service
(www.irs.gov/businesses/small/article/0,,id=98263,00.html):

S corporations are corporations that elect to pass corporate in-come, losses, deductions and credit through to their sharehold-
ers for federal tax purposes. Shareholders of S corporationsreport the ﬂow-through of income and losses on their personal
tax returns and are assessed tax at their individual income tax
rates. This allows S corporations to avoid double taxation on
the corporate income. S corporations are responsible for tax on
certain built-in gains and passive income.

Corporations that do not elect to be treated as S corpora-
tions are called C corporations.
a.How does income get taxed twice in the case of a C corporation?
b.The shareholders of an S corporation are still entitled to limitedliability in the case of bankruptcy of the corporation. What are theadvantages of being an S corporation if an entity can qualify to
do so?
13.The following statement appears in “Agency Costs and Unregulated

Banks: Could Depositors Protect Themselves?” by Catherine England
(Cato Journal 7, no, 3 [Winter 1988]):
The agency costs literature argues that both agents and princi-
pals are aware of the potential conﬂicts of interest and abusesthat can arise in an agency relationship. But neither group is ex-
pected to passively accept the limitations imposed by the poten-
tial problems and inefﬁciencies. The recognition of agency costscreates incentives for both groups to take steps to minimize and

control the problem. To protect their interests, principals have
reason to develop and incorporate contractual terms designedto channel the behavior of agents in desirable directions and/or
to limit their ability to engage in unacceptable activities. In
addition, principals setting a value on agents’ services will con-sider the costs associated with the principal/agent relationship
and reduce accordingly the compensation that would be paid

to agents in a world of perfect information. Faced with the pos-sibility of reduced compensation, agents will not only agree to

Business Finance 107
contractual terms that reassure principals, but will also develop
mechanisms that tend to make principals more conﬁdent.
a.What are agency costs?
b.What can principals do to reduce agency costs?
14.The following two statements were posted on a web site (www.inter
ﬂuidity.com) in a discussion of agency costs and leveraged investment

funds. Leveraged investment funds are funds such as a hedge funds that
borrow a considerable amount of money to investment in securities.
Limited liability creates a potential conﬂict of interest betweeninvestment funds and their creditors. If a fund is heavily lever-aged, fund investors can reap large rewards by assuming risky
positions with the understanding that if those positions go sour,

a large fraction of the cost can be shifted (via actual or threat-ened bankruptcy) to the fund’s creditors.
a.What is meant by “limited liability”?
b.Explain whether you agree or disagree with the excerpt.
Like any other sort of investment manager, the interests of those
who manage funds for pensions, university endowments, and
charitable foundations may diverge from the interests of theirdiverse clientele. In particular, rational, self-interested man-

agers may determine that pursuing peer-competitive short-term
gains is wiser than carefully managing the long-term risks offund stakeholders.
c.What do economists call the types of costs associated with the actionsdescribed in this excerpt?
d.What is meant by “stakeholders”?

108

c06 JWBT310-Fabozzi July 8, 2010 13:5 Printer: Courier Westford, Westford, MA
CHAPTER6
Financial Strategy and
Financial Planning
Though we are delighted with what we own, we are not pleased
with our prospects for committing incoming funds. Prices are highfor both businesses and stocks. That does not mean that the prices
of either will fall—we have absolutely no view on that matter—but

it does mean that we get relatively little in prospective earningswhen we commit fresh money.
Under these circumstances, we try to exert a Ted Williams kind
of discipline. In his book The Science of Hitting, Ted explains that
he carved the strike zone into 77 cells, each the size of a baseball.
Swinging only at balls in his “best” cell, he knew, would allow
him to bat .400; reaching for balls in his “worst” spot, the lowoutside corner of the strike zone, would reduce him to .230. In

other words, waiting for the fat pitch would mean a trip to the
Hall of Fame; swinging indiscriminately would mean a ticket tothe minors.
If they are in the strike zone at all, the business “pitches” we
now see are just catching the lower outside corner. If we swing, we
will be locked into low returns. But if we let all of today’s balls go
by, there can be no assurance that the next ones we see will bemore to our liking. Perhaps the attractive prices of the past were

the aberrations, not the full prices of today. Unlike Ted, we can’t
be called out if we resist three pitches that are barely in the strikezone; nevertheless, just standing there, day after day, with my bat
on my shoulder is not my idea of fun.
Hathaway, 1997
109

110 FINANCIAL MANAGEMENT
Acompany’s strategic plan is a method of achieving the goal of maximizing
shareholder wealth. This strategic plan requires both long- and short-
term ﬁnancial planning that brings together forecasts of the company’s sales
with ﬁnancing and investment decision making. Budgets, such as the cash
budget and the production budget, are used to manage the information

used in this planning, whereas performance measures, such as the balancedscorecard and economic value added, are used to evaluate progress toward
the strategic goals.
Astrategy is a direction the company intends to take to reach an ob-
jective. Once the company has its strategy, it needs a plan, in particular thestrategic plan, which is the set of actions the company intends to use to

follow its strategy. The investment opportunities that enable the companyto follow its strategy comprise the company’s investment strategy.
The chief ﬁnancial ofﬁcer (CFO), under the supervision of the board of
directors, looks at the company’s investment decisions and considers howto ﬁnance them. Budgeting is mapping out the sources and uses of funds
for future periods. Budgeting requires both economic analysis (includingforecasting) and accounting information. Economic analysis includes both

marketing and production analysis to develop forecasts of future sales and
costs. Accounting techniques are used as a measurement device: But insteadof using accounting to summarize what has happened, companies use ac-
counting to represent what the management expects to happen in the future.
Therefore, budgeting involves looking forward into the future. We summa-rize this process in Exhibit 6.1.
Once these plans are put into effect, the management must compare

what happens with what was planned. Companies use this postaudit-ing to:
■Evaluate the performance of management.
■Analyze any deviations of actual results from planned results.
■Evaluate the planning process to determine just how good it is.
The purpose of this chapter is to explain strategic planning and how
ﬁnancial planning and budgeting are used in this process.
STRATEGY AND VALUE
Thestrategic plan is the path that the company intends to follow to achieve

its objective, which is to put its assets to their best use, adding value. In
this strategic plan is a method to make investments that will add value to
the company. The way to add value is to invest in proﬁtable projects. But

Financial Strategy and Financial Planning 111
Define the
objective
Develop a
strategy and a
strategic plan
Develop
budgetsDevelop the
financing
strategy
Evaluate
performanceDevelop the
strategy
EXHIBIT 6.1 Strategy and Budgeting
where do these opportunities come from? They come from the company’s
comparative advantage or its competitive advantages.

Comparative and Competitive Advantages
Acomparative advantage is the advantage one company has over others in
terms of the cost of producing or distributing goods or services. For exam-
ple, Wal-Mart Stores, Inc. had for years a comparative advantage over its
competitors (such as Kmart) through its vast network of warehouses and its
distribution system. Wal-Mart invested in a system of regional warehouses

and its own trucking system. Combined with bulk purchases and a uniquecustomer approach, Wal-Mart’s comparative advantages in its warehousing
and distribution systems helped it grow to be a major (and very proﬁtable)
retailer in a very short span of time. However, as with most comparative ad-vantages, it took a few years for competitors to catch up and for Wal-Mart’s
advantages to disappear.
Acompetitive advantage is the advantage one company has over another

because of the structure of the markets, input and output markets, in whichthey both operate. For example, one company may have a competitive ad-
vantage due to barriers to other companies entering the same market. This

112 FINANCIAL MANAGEMENT
happens in the case of governmental regulations that limit the number of
companies in a market, as with banks, or in the case of government-grantedmonopolies.
A company itself may create barriers to entry (although with the help

of the government) that include patents and trademarks. NutraSweet Com-pany, a unit of Monsanto Company, had the exclusive patent on the artiﬁcial
sweetener, aspartame, which it marketed under the brand name NutraSweet.
However, this patent expired December 14, 1992. The loss of the monopolyon the artiﬁcial sweetener reduced the price of aspartame from $70 per
pound to $20 to $35 per pound, since other companies could produce and

sell aspartame products starting December 15, 1992. NutraSweet had acompetitive advantage as long as it had the patent. But as soon as the patent
expired, this competitive advantage was lost and competitors were lining up
to enter the market.
1Estimates of the value of patents vary by country and
industry, but studies have shown that up to one quarter of the return fromresearch and development is attributed to patents.
The bottom line is that a company invests in something and gets more

back in return only by having some type of advantage. In other words,a comparative or competitive advantage allows the company to generateeconomic proﬁts—that is, proﬁts in excess of its cost of capital. So ﬁrst a
management has to ﬁgure out where the company has a comparative or
competitive advantage before the company’s strategy can be determined.
Strategy and Adding Value

Often companies conceptualize a strategy in terms of the consumers of thecompany’s goods and services. For example, management may have a strat-egy to become the world’s leading producer of microcomputer chips by
producing the best quality chip or by producing chips at the lowest cost,
developing a cost (and price) advantage over its competitors. So manage-
ment’s focus is on product quality and cost. Is this strategy in conﬂict with
maximizing owners’ wealth? No.

Management must focus on the returns and risks of future cash ﬂows
to stockholders in order to add value. And management looks at a project’sproﬁtability when making decisions regarding whether to invest in it. Astrategy of gaining a competitive or comparative advantage is consistent
with maximizing shareholder wealth. This is because proﬁtable projects
arise when the company has a competitive or comparative advantage overother companies.

Financial Strategy and Financial Planning 113
Suppose a new piece of equipment is expected to generate a return
greater than what is expected for the project’s risk (that is, greater than its
cost of capital). But how can a company create value simply by investing
in a piece of equipment? How can it maintain a competitive advantage?

If investing in this equipment can create value, wouldn’t the company’scompetitors also want this equipment? Of course—if they could use it to
create value, they would surely be interested in it.
Now suppose that the company’s competitors face no barriers to buying
the equipment and exploiting its beneﬁts. What will happen? The companyand its competitors will compete for the equipment, bidding up its price.

When does it all end? It ends when the difference between the present value ofthe inﬂows and the present value of the outﬂows for the equipment is zero.
2
Suppose instead that the company has a patent on the new piece of
equipment and can thus keep its competitors from exploiting the equipment’s
beneﬁts. Then there would be no competition for the equipment and the
company would be able to exploit it to add value.
Our acquisition decisions will be aimed at maximizing real eco-

nomic beneﬁts, not at maximizing either managerial domain or
reported numbers for accounting purposes. (In the long run, man-
agements stressing accounting appearance over economic substance
usually achieve little of either.)
—Warren Buffett, Letter to Shareholders of
Berkshire Hathaway, 1981
Consider an example where trying to gain a comparative advantage

went wrong. Schlitz Brewing Company attempted to reduce its costs to gainan advantage over its competitors: It reduced its labor costs and shortenedthe brewing cycle. Reducing costs allowed it to reduce its prices below
competitors’ prices. But product quality suffered—so much that Schlitz lost
market share, instead of gaining it. Schlitz Brewing attempted to gain acomparative advantage, but was not true to a larger strategy to satisfy its

customers—who apparently wanted quality beer more than they wanted
cheap beer. And the loss of market share was reﬂected in Schlitz’s decliningstock price.
3
2As you will see later in Chapter 13, this is when the net present value is equal to
zero.
3The case of Schlitz Brewing is detailed in George S. Day and Liam Fahey,
“Putting Strategy into Shareholder Value Analysis,” Harvard Business Review 68
(March–April 1990): 156–162.

114 FINANCIAL MANAGEMENT
Value can be created only when the company has a competitive or
comparative advantage. If a company analyzes a project and determines
that it is proﬁtable, the ﬁrst question should be: Where did these proﬁts
come from?
Financial Planning and Budgeting
A strategy is the direction a company takes to meet its objective, whereas a

strategic plan is how a company intends to go in that direction. For man-
agement, a strategic investment plan includes policies to seek out possible
investments. A strategic plan also includes resource allocation. If a company
intends to expand, where does it get the capital to do so? If a company re-
quires more capital, the timing, amount, and type of capital (whether equityor debt) comprise elements of a company’s ﬁnancial strategic plan. These

things must be planned to implement the strategy.
Financial planning allocates a company’s resources to achieve its invest-
ment objectives. Financial planning is important for several reasons. First,ﬁnancial planning helps managers assess the impact of a particular strategy
on their company’s ﬁnancial position, its cash ﬂows, its reported earnings,and its need for external ﬁnancing.
By failing to prepare you are preparing to fail.

Second, by formulating ﬁnancial plans, management is in a better po-
sition to react to any changes in market conditions, such as slower thanexpected sales, or unexpected problems, such as a reduction in the supply ofraw materials. By constructing a ﬁnancial plan, management becomes more
familiar with the sensitivity of the company’s cash ﬂows and its ﬁnancing
needs to changes in sales or some other factor.

Third, creating a ﬁnancial plan helps management understand the trade-
offs inherent in its investment and ﬁnancing plans. For example, by develop-ing a ﬁnancial plan, management is better able to understand the trade-off
that exists between having sufﬁcient inventory to satisfy customer demands
and the need to ﬁnance the investment in inventory.
Financial planning consists of the company’s investment and ﬁnancing

plans. Once we know the company’s investment plan, management needsto ﬁgure out when funds are needed and where they will come from. Thisis accomplished by developing a budget , which is basically the company’s
investment and ﬁnancing plans expressed in monetary terms. A budget canrepresent details such as what to do with cash in excess of needs on a daily

Financial Strategy and Financial Planning 115
basis, or it can reﬂect broad statements of a company’s business strategy
over the next decade. Exhibit 6.2 illustrates the budgeting process.
Budgeting for the short term (less than a year) is usually referred to as
operational budgeting ; budgeting for the long term (typically three to ﬁve

years ahead) is referred to as long-run planning orlong-term planning. But
since long-term planning depends on what is done in the short term, the
operational budgeting and long-term planning are closely related.
THE BUDGETING PROCESS
The budgeting process involves putting together the ﬁnancing and invest-
ment strategy in terms that allow those responsible for the ﬁnancing of thecompany to determine what investments can be made and how these invest-

ments should be ﬁnanced. In other words, budgeting pulls together decisions
regarding capital budgeting, capital structure, and working capital.
Consider a company whose line of business is operating retail stores.
Its store renovation plan is part of its overall strategy of regaining its shareof the retail market by offering customers better quality and service. Fixingup its stores is seen as an investment strategy. The company evaluates its

renovation plan using capital budgeting techniques (e.g., net present value).
But the renovation program requires ﬁnancing—this is where the capitalstructure decision comes in. If it needs more funds, where do they come from?
Debt? Equity? Both? And let’s not forget the working capital decisions.
As the company renovates its stores, will this change its need for cash onhand? Will the renovation affect inventory needs? If the company expects

to increase sales through this program, how will this affect its investment
in accounts receivable? And what about short-term ﬁnancing? Will it need
more or less short-term ﬁnancing when it renovates?
It’s clearly a budget. It’s got a lot of numbers in it.
—George W. Bush
While the company is undergoing a renovation program, it needs to es-
timate what funds it needs, in both the short and the long run. This is where

cash budget and pro forma ﬁnancial statements are useful. The startingpoint is generally a sales forecast, which is related closely to the purchasing,
production, and other forecasts of the company. What are the company’s
expected sales in the short term? In the long term? Also, the amount that thecompany expects to sell affects its purchases, sales personnel, and advertis-
ing forecasts. Putting together forecasts requires cooperation among Sears’s
marketing, purchasing, and ﬁnance staff.

116 FINANCIAL MANAGEMENT
Once the company has its sales and related forecasts, the next step is a
cash budget, detailing the cash inﬂows and outﬂows each period. Once the
cash budget is established, pro forma balance sheet and income statements
can be constructed. Following this, the company must verify that its budget
is consistent with its objective and its strategies.

Budgeting generally begins four to six months prior to the end of the
current ﬁscal period. Most companies have a set of procedures that must befollowed in compiling the budget. The budget process is usually managedby either the CFO, a vice president of planning, the director of the budget,
the vice president of ﬁnance, or the controller. Each division or department
provides its own budgets that are then merged into a company’s centralizedbudget by the manager of the budget.

A budget looks forward and backward. It identiﬁes resources that the
company will generate or need in the near and long term, and it serves
as a measure of the current and past performance of departments, divi-
sions, or individual managers. But management has to be careful whenmeasuring deviations between budgeted and actual results to separately
identify deviations that were controllable from deviations that were un-

controllable. For example, suppose management develops a budget expect-ing $10 million sales from a new product. If actual sales turn out to be
$6 million, do we interpret this result as poor performance on the part of
management? Maybe, maybe not: If the lower-than-expected sales are dueto an unexpected downturn in the economy, probably not; but yes, if they
are due to what turns out to be obviously poor management forecasts of
consumer demand.
Sale Forecasting

Sales forecasts are an important part of ﬁnancial planning. Inaccurate fore-casts can result in shortages of inventory, inadequate short-term ﬁnancing
arrangements, and so on.
If a company’s sales forecast misses its mark, either understating or
overstating sales, there are many potential problems. Consider Nintendo,which missed its mark. This company introduced the Wii game console

in November 2006, which enjoyed runaway popularity. In fact, this gameconsole was so popular that Nintendo could not keep up with demand. It
was in such demand and inventory so depleted that Nintendo was selling
the game faster than they produced them.
4
4It was not until 2009 that Nintendo’s supply of Wii game consoles caught up to its
demand.

Financial Strategy and Financial Planning 117
Nintendo missed its mark, signiﬁcantly underestimating the demand for
Wii. While having a popular game console may seem like a dream for a
company, this product created problems. With no Wii game consoles on
store shelves, other manufacturers with gaming systems with similar (but

not identical) features, were able to capture some of Nintendo’s market.Also, consumers may begrudge the company for creating the demand for
the game through advertising, but not having sufﬁcient game consoles to
satisfy the demand.
To predict cash ﬂows management forecasts sales, which are uncertain

because they are affected by future economic, industry, and market condi-tions. Nevertheless, management can usually assign meaningful degrees ofuncertainty to its forecasts. Sales can be forecasted by regression analysis,
market surveys, or opinions of management.
Forecasting with Regression Analysis
Regression analysis is a statistical method that enables us to ﬁt a straight line
that on average represents the best possible graphical relationship between

sales and time. This best ﬁt is called the regression line. One way regression
analysis can be used is to simply extrapolate future sales based on the trendin past sales. Another way of using regression analysis is to look at therelation between two measures, say, sales and capital expenditures.
While regression analysis gives us what may seem to be a precise measure
of the relationship among variables, there are a number of warnings that
management must heed in using it:

■Using historical data to predict the future assumes that the past rela-
tionships will continue into the future, which is not always true.
■The period over which the regression is estimated may not be repre-
sentative of the future. For example, data from a recessionary period
of time will not tell much about a period that is predicted to be an
economic boom.
■The reliability of the estimate is important: If there is a high degree of

error in the estimate, the regression estimates may not be useful.
■The time period over which the regression is estimated may be too shortto provide a basis for projecting long-term trends.
■The forecast of one variable may require forecasts of other variables.
For example, the management may be convinced that sales are affected
by gross domestic product (GDP) and use regression to analyze thisrelationship. But to use regression to forecast sales, management must

ﬁrst forecast GDP. In this case, management’s forecast of sales is only
as good as the forecast of GDP.

118 FINANCIAL MANAGEMENT
Market Surveys
Market surveys of customers can provide estimates of future revenues. In
the case of Intel, for example, management would need to focus on the
computer industry and, speciﬁcally, on computer, netbooks, phones, and

gaming markets. For each of these markets, management would have toassess Intel’s market share and also the expected sales for each market.
Management should expect to learn from these market surveys:
■Product development and introductions by Intel and its competitors
■The general economic climate and the projected expenditures on com-
puters and other electronic devices that require microprocessors
In general, management can use the company’s own market survey

department to survey its customers. Or it can employ outside market survey
specialists.
Management Forecasts
In addition to market surveys, the company’s managers may be able to pro-
vide forecasts of future sales. The experience of a company’s management
and their familiarity with the company’s products, customers, and competi-tors make them reliable forecasters of future sales.
The company’s own managers should have the expertise to predict the

market for the goods and services and to evaluate the costs of producingand marketing them. But there are potential problems in using manage-
ment forecasts. Consider the case of a manager who forecasts rosy out-
comes for a new product. These forecasts may persuade the company toallocate more resources—such as a larger capital budget and additional
personnel—to that manager. If these forecasts come true, the company
will be glad these additional resources were allocated. But if these fore-

casts turned out to be too rosy, the company has unnecessarily allocated
these resources.
Forecasting is an important element in planning for both the short and
the long term. But forecasts are made by people. Forecasters tend to beoptimistic, which usually results in rosier-than-deserved forecasts of futuresales. In addition, people tend to focus on what worked in the past, so past
successes carry more weight in developing forecasts than an analysis of the

future. One way to avoid this is to make managers responsible for theirforecasts, rewarding accurate forecasts and penalizing managers for being
way off the mark.

Financial Strategy and Financial Planning 119
BUDGETING
In budgeting, we bring together analyses of cash ﬂows, projected income
statements, and projected balance sheets. The cash ﬂow analyses are most
important, though the ﬁnancial management staff needs to generate the
income statement and balance sheet as well.
Most companies extend or receive credit, so cash ﬂows and net income

do not coincide. Typically, the ﬁnance staff must determine cash ﬂows fromaccounting information on revenues and expenses. For example, combiningsales projections with estimates of collections of accounts receivable results
in an estimate of cash receipts.
The Cash Budget
Acash budget is a detailed statement of the cash inﬂows and outﬂows
expected in future periods. This budget helps management identify ﬁnancing

and investment needs. A cash budget can also be used to compare actualcash ﬂows against planned cash ﬂows so that management can evaluate both
management’s performance and management’s forecasting ability.
Cash ﬂows come into the company from:
■Operations, such as receipts from sales and collections on accountsreceivable
■The results of ﬁnancing decisions, such as borrowings, sales of shares of
common stock, and sales of preferred stock

■The results of investment decisions, such as sales of assets and incomefrom marketable securities
Cash ﬂows leave the company from:
■Operations, such as payments on accounts payable, purchases of goods,
and the payment of taxes
■Financing obligations, such as the payment of dividends and interest,
and the repurchase of shares of stock or the redemption of bonds
■Investments, such as the purchase of plant and equipment

As we noted before, the cash budget is driven by the sales forecast. The
cash budget, by providing estimates of cash inﬂows and outﬂows, provides
an estimate of the company’s need for funds, requiring short- or long-termcapital, or excess funds, requiring the company to invest the funds, pay
down debt, or return capital to owners.

120 FINANCIAL MANAGEMENT
Pro Forma Financial Statements
Apro forma balance sheet is a projected balance sheet for a future period—a
month, quarter, or year—that summarizes assets, liabilities, and equity.5A
pro forma income statement is the projected income statement for a future
period—a month, quarter, or year—that summarizes revenues and expenses.

Together both projections help management identify the company’s invest-
ment and ﬁnancing needs.
PERFORMANCE EVALUATION
Planning and forecasting are important, but without some type of perfor-
mance evaluation, the execution of a strategy and the accuracy of forecasting
cannot be addressed. There are many performance evaluation measures and
systems available. We will address two of these, economic value added andthe balanced scorecard, to provide examples of how these may assist in

assessing performance.
Economic Value Added
Arising from the need for better methods of evaluating performance, severalconsulting companies advocate performance evaluation methods that are
applied to evaluate a company’s performance as a whole and to evaluate
speciﬁc managers’ performances. These methods are, in some cases, sup-
planting traditional methods of measuring performance, such as the returnon assets discussed in other chapters of this book. As a class, these mea-

sures are often referred to as value-based metrics or economic value–added
measures. There is a cacophony of acronyms to accompany these measures,including economic value added (EVA
R⃝), market value added (MVA), cash
ﬂow return on investment (CFROI), shareholder value added (SVA), cashvalue added (CVA), and reﬁned economic value added (REVA).
6
A company’s management creates value when decisions provide beneﬁts

that exceed the costs. These beneﬁts may be received in the near or distantfuture. The costs include both the direct cost of the investment as well as the
5You should not confuse a pro forma ﬁnancial statement with pro forma earnings
that a company may announce. Pro forma earnings, in the latter context, are earnings
restated using principles that are not generally accepted accounting principles.
6For a further discussion of these measures, see Frank J. Fabozzi and James L. Grant

(eds.), Value Based Metrics: Foundations and Practice (Hoboken, NJ: John Wiley &
Sons, 2000).

Financial Strategy and Financial Planning 121
less obvious cost, the cost of capital. The cost of capital is the explicit and
implicit costs associated with using investors’ funds. The attention to thecost of capital sets the value-based metrics apart from traditional measures
of performance such as the return on investment.

There are a number of value-added measures available. The most com-
monly used measures are economic value added and market value added.Economic value added ,a l s or e f e r r e dt oa seconomic proﬁt , is the difference
between operating proﬁts and the cost of capital, where the cost of capital
is expressed in dollar terms. We diagram the key elements of estimating
economic value added in Exhibit 6.2.

We continue to use Economic Value Added as the basis for disci-plined decision making around the use of capital. EVA is a tool that
considers both ﬁnancial earnings and a cost of capital in measuringperformance. We look for opportunities to improve EVA because
we believe there is a strong correlation between EVA improvement
and creation of shareholder value.
—The Williams Companies, 2007 Annual Report

The difference between the operating proﬁt and the cost of capital is the
estimate of the company’s economic value added, or economic proﬁt. Thecost of capital is the rate of return required by the suppliers of capital to the
company. For a business that ﬁnances its operations or investments using
both debt and equity, the cost of capital includes not only the explicit intereston the debt, but also the implicit minimum return that owners require. This

122 FINANCIAL MANAGEMENT
minimum return to owners is necessary so that owners keep their investment
capital in the company.
A measure closely related to economic proﬁt is market valued added.

Market value added is the difference between the company’s market valueand its capital. Essentially, market value added is a measure of what thecompany’s management has been able to do with a given level of resources
(the invested capital): Market value added is the difference between the
market value of the company (that is, debt and equity), less the capitalinvested. Like economic proﬁt, market value added is in terms of dollars

and the goal of the company is to increase added value. Calculating the
market value added requires comparing the market value of a company’scapital with the capital invested; the difference between these two amounts
is the market value added. The primary distinction between economic value
added and market value added is that the latter incorporates market data in
the calculation.
Balanced Scorecard

The traditional measures of a company’s performance are generally histor-ical, ﬁnancial measures. With the popularity of economic value added and
market value measures, many companies began to adopt forward-lookingﬁnancial measures. Taking a step further, many companies are adopting the
concept of a balanced scorecard. A balanced scorecard is a set of measures
of performance that address different aspects of a company’s strategic plan.

A balanced scorecard is a management tool used to:
■Help put a company’s strategic plan into action
■Use measurement devices to evaluate performance relative to the strate-gic plan
■Provide feedback mechanisms to allow for continuous improvement
toward the strategic goals
Robert Kaplan and David Norton developed the concept of a balanced
scorecard to address the need of companies to balance the needs of cus-

tomers, ﬁnancial needs, internal management needs, and the needs for inno-vation and learning within the enterprise.
7They contend that single metrics
do not adequately address the strategic objectives of a company; rather, mul-tiple measures—both lagging and leading indicators—should be used to meet
7Robert S. Kaplan and David P. Norton, The Balanced Scorecard , (Boston: Harvard
Business School Press, 1996); and Robert S. Kaplan and David P. Norton, The

Strategy-Focused Organization (Boston: Harvard Business School Press, 2001).

Financial Strategy and Financial Planning 123
Step 4: Providing
feedback on units’
performance and
company
Step 3: Planning,
budgeting, and
target settingStep 2:
Communicating and
linking the
different business
units’ measures to
the company’s
strategyStep 1:
Understanding the
company’s strategy
and vision
EXHIBIT 6.3 The Balanced Scorecard Process

a company’s strategic goals. These measures, referred to as key performance
indicators, include short-term and long-term measures, ﬁnancial and non-
ﬁnancial measures, and historical and leading measures. The balanced score-
card, therefore, goes beyond the traditional ﬁnancial measures of the rate ofreturn and proﬁtability to capture other dimensions of a company’s perfor-
mance and use this information to help attain the company’s strategic goals.

The balanced scorecard is really a process of assessing the effectiveness
of the company’s strategy in meeting the company’s objective, identifyingmeasures to evaluate whether the company is meeting its short-term and
long-term goals, setting targets, and then providing feedback from these
measures. We illustrate this process in Exhibit 6.3. The actual balanced

scorecard does not prescribe the measures to use, but rather speciﬁes thedimensions of the company that should be considered in the system.
The developers of the balanced scorecard argue that measures and met-
rics used to evaluate different business units and the company should repre-sent different dimensions of performance, including ﬁnancial performance,
customer relations, internal business processes, and organizational learning

and growth. We illustrate these dimensions in Exhibit 6.4. However, nospeciﬁc measures are prescribed; rather, the choice of measures should be
tailored to the company’s individual situation. The basic idea, however, is
to select the key performance indicators that capture the four dimensions.

124 FINANCIAL MANAGEMENT
Financial
Internal
business
processesOrganizational
learning and
growthCustomer
relationsReturn on investment
Net profit margin
Economic value added
Market value added
Growth rate of revenuesCustomer profitability
Number of customer complaints
Customer surveys
Repeat customers
On-time delivery
Customer profitabilityRepeat customers

On-time deliveryEmployee motivation
Employee empowerment
Employee capabilities
Hours spent on training employees
EXHIBIT 6.4 Possible Performance Indicators in Four Dimensions of Strategy
Within each of these dimensions, there may be any number of different
measures. These measures are generally tailored to the speciﬁc business
and should be consistent with the company’s or unit’s goals. We provide a

number of possible metrics within each of these dimensions in Exhibit 6.4.
STRATEGY AND VALUE CREATION
The company’s chief ﬁnancial ofﬁcer is in a good position to link the corpo-
rate strategy with value creation. Most surveys indicate that CFOs feel that
their focus is shifting from historical assessment of performance to forward-looking tasks such as the development of strategy and decision making.
For example, a March 2006 report prepared by CFO Research Services

in collaboration with Deloitte Consulting found that CFOs not only par-ticipate in the development of a company’s strategy, but in many cases the

Financial Strategy and Financial Planning 125
CFO is also charged with executing the strategy and measuring the com-
pany’s progress toward the strategic goals.8The CFO role has expanded
from the traditional functions—controller, ﬁnancial reporting, compliance,
and support—to include serving the company’s strategy through ﬁnancial

decision making. This expansion has broadened the role from a servicefunction to an activist function. According to an April 2005 report prepared
by CFO Research Services and Booz Allen Hamilton:
9
Activism—again, deﬁned as ﬁnance in a role beyond controller-ship and decision support—occurs more often among survey re-
spondents who say their ﬁnance teams have become more closelyengaged with the board of directors in the last two years.

This survey, however, indicates that those companies with closer re-
lations with the board of directors are also companies that have greater
pressure from analysts, high turnover in top management, and a need to
change the company’s operating model—in other words, those companiesunder the microscope of the business community.
It is interesting that surveys suggest an inconsistency in the CFO’s role
in a company’s strategy and value creation.
10The majority of CFOs feel that

strategy is their top priority, yet they also feel that this is not the perception
of the CFO’s role among other functions within the company:
...found that 60% of the CFOs surveyed cite their role in the
development/formulation of corporate strategy as a priority. Yet
only 25% say the rest of the organization views ﬁnance as a valueadded function to be consulted on all important decisions.
A 2005 survey by Financial Executives International Canada, “The Role

of the CFO Today and Beyond,” found that CFOs are directly accountable
for ﬁnancial analysis (93%), ﬁnancial risk management (92.3%), forecast-
ing and projections (87.3%), business and ﬁnancial systems and reporting
(82.4%), and ﬁnancing and capital structure changes (79.6%). In terms of
functions in which CFOs are closely involved, the top three functions are

involvement in the operational risk management (70.4%), writing some orall of the strategic plan (69%), and strategic and business planning (59.9%).
The results of this survey illustrate the breadth of the CFO’s responsibility.
8“Different Paths to One Truth: Finance Brings Value Discipline to Strategy
Execution.”
9CFO Research Services and Booz Allen Hamilton, “The Activist CFO—Alignment
with Strategy, Not Just with the Business,” p. 15.

10Mark Frigo, The State of Management Accounting: The Ernst & Young and IMA
Survey, Institute of Management Accounts Research Team Member, 2003, p. 7.

126 FINANCIAL MANAGEMENT
EXHIBIT 6.5 Porter’s Five Forces
Sources of Value Creation
A company’s strategy is a path to create value. But value cannot be created
out of thin air. Value creation—that is, generating economic proﬁt—requires
identifying comparative and competitive advantages, and developing a strat-
egy that exploits these advantages.

One way to look at these advantages is to use the framework intro-
duced by Michael Porter.11He analyzed competitive structure of industries
and identiﬁed ﬁve competitive forces that capture an industry’s competitive
rivalry, as we illustrate in Exhibit 6.5. Porter’s Five Forces relate to the
company’s or industry’s ability to generate economic proﬁts. Brieﬂy,

■The bargaining power of suppliers relates to the power of the providersof inputs—both goods and services.
■The bargaining power of buyers relates to the power of those who buythe company’s goods and services.
■The threat of new entrants is related to barriers to entry into the
industry.12
■The threat of substitutes relates to alternative goods and services the
company’s customers may buy.

■The competitive rivalry among existing members of the industry is af-fected by the number and relative size of the companies in the industry,the strategies of the companies, the differentiation among products, and
the growth of the sales in the industry.
11Michael Porter, Competitive Strategy: Techniques for Analyzing Industries and
Competitors (New York: Simon & Schuster, 1998).
12A barrier to entry is an impediment such as economies of scale, high initial start-

up costs, cost advantages due to experience of existing participants, loyalty among
customers, protections such as patents, licenses, or copyrights, or regulatory or
government action that limits entrants into the industry.

Financial Strategy and Financial Planning 127
EXHIBIT 6.6 Porter’s Five Forces: Threats and Powers
Force High Low
Bargaining
power of
buyersBuyers are concentrated.
Suppliers have high ﬁxed costs.
Ready substitutes.
Buyer could produce the good or
service itself.Many potential buyers.Buyer volume is low.
Few substitutes.
Buyers cannot backward
integrate.
power of

power of
suppliersThe market is dominated by a few
large companies.
There are no substitutes for the
input.
The cost of switching inputs is high.The buyers are fragmented with
little buying power.
The suppliers may integrate forward
to capture higher prices and
margins.Many suppliers.Readily available substitutes.
Low cost to switching inputs.
Threat of
new
entrantsFew barriers to entry.
Little customer loyalty.

Low capital requirements.High proﬁts.Signiﬁcant barriers to entry.
Strong customer loyalty.
High learning curve.Signiﬁcant capital investment.
Threat of
substitutesLittle brand loyalty among
customers.
No close customer relations.
Low costs to switching goods and
services.
Substitutes are lower priced.High brand loyalty.
Strong customer relations.High costs to switching
goods.
Substitutes are not lower
priced.
Rivalry High barriers to exit.

priced.
Concentrated industry.Low barriers to entry.
Large number of ﬁrms.
Slow growth.Low costs for customers to switch
products.
High ﬁxed costs.Low barriers to exit.High barriers to entry.Signiﬁcant product
differentiation.
High costs for customers to
switch products.
We provide examples of how characteristics of the industries (the prod-
ucts, suppliers, and market structure) affect the rivalry among companies

in an industry in Exhibit 6.6. For example, if buyers are concentrated, thebargaining power of buyers is high, which makes it more difﬁcult for com-
panies to extract economic proﬁts. On the other hand, if there are many
suppliers, the power of the suppliers is low and companies in this industrymay be able to extract more economic proﬁt.

128 FINANCIAL MANAGEMENT
Porter’s Five Forces do not provide a magic formula for determining
whether a company can create value. Rather, the purpose of the ﬁve forces
is to provide a framework for thinking about the powers and threats that
affect an industry’s—and company’s—ability to generate economic proﬁts.

The bottom line of all of this is that the ability of a company to create andmaintain a comparative or competitive advantage is complex.
Porter’s forces are, basically, an elaboration of the theories of economics
that tell us how a company creates economic proﬁt. Though Porter’s forcesmay seem over simplistic in a dynamic economy, they provide a starting
point for analysis of a company’s ability to add value. Porter argues that

an individual company may create a competitive advantage through relativecost, differentiation, and relative prices. Management, in evaluating a com-
pany’s current and future performance, can use these forces and strategies
to identify the company’s sources of economic proﬁt.
Management should never ignore the basic economics that lie behind
value creation. If a company has a unique advantage, this can lead to valuecreation. If the advantage is one that can be replicated easily by others, this

advantage—and hence any value creation related to it—may erode quickly.
The herding behavior of companies, seeking to mimic the strategies of thebetter-performing companies, may result in the erosion of value from that
strategy. This herding behavior therefore requires that strategic planning be
dynamic and that feedback from performance evaluation is important inthis planning process. Therefore, strategic planning should be a continual

process that requires setting strategic objectives, developing the strategy,
periodically measuring progress toward those goals, and then reevaluatingthe strategic objectives and strategy.
■Adding value to a company requires devising a strategy and a strategicplan to exploit the company’s comparative or competitive advantages.
■An important element in ﬁnancial planning for a business is forecasting
revenues and expenses, and then developing the budgets.

■Evaluating a company’s performance requires estimating the company’s
economic proﬁt and measuring its value-added. A useful tool is to use a
balanced scorecard process, which begins with the company’s strategy
and requires measurement and feedback of the company’s performance,as well as that of the different units of the company.
■Porter’s Five Forces framework is useful in identifying the degree ofrivalry in an industry by focusing on the company’s bargaining power

Financial Strategy and Financial Planning 129
with suppliers, the buyers’ bargaining power with the company, the
threat of new entrants in the industry, and the threat of substitutes.
QUESTIONS
1.What is the relation between a strategy and an objective?
2.How are comparative advantages different from competitive advan-tages?
3.What is a strategic plan?

4.What is a ﬁnancial plan, and how does it relate to a company’s strategicplan?
5.What is regression analysis, and how might it assist a ﬁnancial manager
in planning?
6.What is a pro forma ﬁnancial statement?
7.What is economic value added and why do ﬁnancial managers careabout this?
8.Explain what is meant by a balanced scorecard.

9.If companies in an industry have signiﬁcant proﬁts and there are no bar-riers to entry, how do these characteristics ﬁt in the context of Porter’s
Five Forces?
10.What are sources of economic proﬁts for a company or an industry?
11.The following is an excerpt that appeared in an article “Strategic Plan-ning: Not Just for Big Business” published at www.smallbusinessnotes.
com/planning/strategicplanning.html, sponsored by “Strategic Planning

Made Easy”:
Strategic planning has become a concept that is commonly sug-gested as the “solution” to many business problems. Some
days it appears that the chief product of many businesses is
their strategic plan. Don’t misunderstand me, strategic plans
are wonderful when used appropriately, but they do need to
be a tool of a business, not a goal unto themselves. And, mostdeﬁnitely, they should not be a major consumer of valuable
employer/employee time.

Many entrepreneurial ventures mistakenly believe that
strategic planning is only for large businesses that can affordthe time and personnel to develop a sound plan. However, if
you are to compete in the marketplace against the “big guys,”you need to learn some of their game plans—and strategic plan-
ning is a major part of any successful, large business. That does
not mean that your startup needs all the bells and whistles of

130 FINANCIAL MANAGEMENT
the more complex plans. You can in a matter of hours sketch
out a good working draft that will help keep you on course to
becoming a solid competitor.
a.How does a “strategic plan” relate to a company’s objectives?
b.Why are strategic plans considered a tool and not a solution?

12.The following excerpt is from “Integrating Strategic and Financial Plan-ning” by Lee Ann Runy (2005), which appeared on hospitalconnect.com(www.hhnmag.com/hhnmag
app/hospitalconnect/search/article.jsp?
dcrpath=HHNMAG/PubsNewsArticle/data/0506HHN FEA Gatefold
&domain=HHNMAG):
Integrating strategic and ﬁnancial planning is the best way
for health care organizations to ensure that they are spending
money wisely. ...Too often, projects get approved only to be

shelved because the money isn’t available. And, hospitals need
an accurate vision of their community and the needs and wants
of their customers before embarking on costly expansions andnew services.
It is a dynamic process: Just as budgets must be updated
yearly, strategic plans must be reassessed to ensure that the or-
ganization’s assumptions and projections are on track. It is im-

portant that plans remain up-to-date or the organization riskscostly, unnecessary expenditures or may miss out on a good
opportunity.
A thorough planning process incorporates strategic plan-
ning, ﬁnancial and operational planning and capital allocation.“A ﬁnancial plan without strategy isn’t much of a plan,” says
Blaine O’Connell, chief ﬁnancial ofﬁcer at Froedert Hospitalin Milwaukee. “A strategic plan without ﬁnancial backing isn’t
much of a strategy.”

a.What is the relationship between strategic planning and ﬁnancial
planning?
b.What does ﬁnancial planning involve?
c.What do you think “operational planning” means in the excerpt?
d.What do you think “capital allocation” means in the excerpt?
e.Explain why you agree or disagree with the statement in the excerpt:“A ﬁnancial plan without strategy isn’t much of a plan.”
13.Fortune Magazine published a 1998 interview with Peter Drucker

(“Peter Drucker Takes the Long View: The Original ManagementGuru shares his vision of the future with Fortune’s Brent Schlender”)

Financial Strategy and Financial Planning 131
where the following appeared (money.cnn.com/magazines/fortune/
fortune archive/1998/09/28/248706/index.htm):
...there is no proﬁt unless you earn the cost of capital.
Alfred Marshall said that in 1896, Peter Drucker said that in1954 and in 1973, and now EVA (economic value added) has
systematized this idea, thank God.

a.What is EVA and how does it take into account the cost of capital?
b.What is the relationship between EVA and economic proﬁt?
14.In “Using the Balanced Scorecard as a Strategic Management System”by Robert S. Kaplan and David P. Norton (Harvard Business Review,
January–February 1996), the following appeared on page 2 of the
article:
Managers using the balanced scorecard do not have to rely onshort-term ﬁnancial measures as the sole indicators of the com-

pany’s performance. The scorecard lets them introduce fournew management processes that, separately and in combina-
tion, contribute to linking long-term strategic objectives with
short-term actions.
a.How does a balanced scorecard assist in linking objectives with ac-tions?
b.What are the “four new management processes” mentioned in the
quote?

132

c07 JWBT310-Fabozzi July 8, 2010 13:6 Printer: Courier Westford, Westford, MA
CHAPTER7
Dividend and Dividend Policies
The evidence that, controlling for characteristics, ﬁrms become less
likely to pay dividends says that the perceived beneﬁts of dividends
have declined through time. Some (but surely not all) of the
possibilities are: (i) lower transactions costs for selling stocks forconsumption purposes, in part due to an increased tendency to

hold stocks via open end mutual funds; (ii) larger holdings of stock
options by managers who prefer capital gains to dividends; and(iii) better corporate governance technologies (e.g., more prevalent
use of stock options) that lower the beneﬁts of dividends in
controlling agency problems between stockholders and managers.
—Eugene F. Fama and Kenneth R. French,
“Disappearing Dividends: Changing Firm
Characteristics or Lower Propensity to Pay?”
Journal of Financial Economics 60 (2001): 3–43

Many corporations pay cash dividends to their shareholders despite the
tax consequences of these dividends and the fact that these funds could
otherwise be plowed back into the corporation for investment purposes.
These dividends are often viewed as a signal of the corporation’s future
prosperity. Corporations may also “pay” stock dividends or split the stock,
dividing the equity pie into smaller pieces, the announcement of which is

often viewed as positive news by investors.
In addition to dividends, a corporation can distribute funds to share-
holders other than in the form of a cash dividend. For example, a corpo-ration may repurchase its shares from shareholders through open market
purchases, tender offers, or targeted block repurchases.
The purpose of this chapter is to describe the mechanisms of providing
funds to shareholders in the form of dividends, stock dividends and splits,and stock repurchases.
133

134 FINANCIAL MANAGEMENT
DIVIDENDS
Adividend is the cash, stock, or any type of property a corporation dis-
tributes to its shareholders. The board of directors may declare a dividend
at any time, but dividends are not a legal obligation of the corporation—it

is the board’s choice. Unlike interest on debt securities, if a corporation doesnot pay a dividend, there is no violation of a contract, nor any legal recourse
for shareholders.
When the board of directors declares a distribution, it speciﬁes the
amount of the distribution, the date on which the distribution is paid, andthedate of record , which determines who has the right to the distributions.
Because shares are traded frequently and it takes time to process transac-

tions, the exchanges have devised a way of determining which investors
receive the dividend: the exchanges take the record date, as speciﬁed by the
board of directors, and identify the ex-dividend date, which is two business
days prior to the record date. The ex-dividend date is often referred to simplyas the ex-date.
Therefore, there are four key dates in a distribution:
1.Thedeclaration date, which is the date the board declares the distribu-
tion.

tion.
2.Theex-dividend date, which is the date that determines which investors
receive the dividend. Any investor who owns the stock the day before
the ex-date receives the forthcoming dividend. Any investor who buys
the stock on the ex-date does not receive the dividend.
3.Thedate of record , which is speciﬁed by the board of directors as the
date that determines who receives the dividend.
4.Thepayment date, which is the day the distribution is made.

Most dividends are in the form of cash. Cash dividends are payments
made directly to shareholders in proportion to the shares they own. When
cash dividends are paid, they are paid on all outstanding shares of a
class of stock.
1A few companies pay special dividends orextra dividends
occasionally—identifying these dividends apart from their regular dividends.
We usually describe the cash dividends that a company pays in terms of
dividend per share, which we calculate as:

Dividend per share =Cash dividends
Number of shares outstanding
1Therefore, a corporation may pay dividends on its preferred stock, but not on its
common stock.

Dividend and Dividend Policies 135
Another way of describing cash dividends is in terms of the percentage
of earnings paid out in dividends, which we refer to as the dividend payout
ratio. We can express the dividend in terms of the proportion of earnings
over a ﬁscal period:
Dividend payout ratio =Cash dividends
Earnings available to shareholders

If we take this last equation and divide both the numerator and the
denominator by the number of common shares outstanding, we can rewrite
the dividend payout ratio as:
Dividend payout ratio =Dividend per share
Earnings per share
The dividend payout ratio is the complement of the retention ratio,a l s o
referred to as the plowback ratio:
Retention ratio =Earnings available to shareholders −Cash dividends

=1−Dividend payout ratio
The retention ratio is the proportion of earnings that the company retains,
that is, the proportion of earnings reinvested back into the company.
We demonstrate these calculations in Exhibit 7.1, applying these calcu-
lations to Wal-Mart Stores, Inc.
EXHIBIT 7.1 The Dividends of Wal-Mart Stores, Inc.
For ﬁscal year 2008, Wal-Mart Stores reported the following ﬁnancial results:
Earnings available to common shares $13.400 billion

Dividends paid $ 3.746 billion
Number of common shares outstanding 3.81 billion
Therefore, Wal-Mart Stores’ dividend per share and dividend payout ratio are:
Dividend per share =$3.746 billion / $3.81 billion =$0.9832 per share
Dividend payout ratio =$3.746 billion / $13.400 billion =27.955%
Or, in terms of dividends per share and earnings per share, we get the same result:
Dividend payout ratio =$0.9832 / $3.5171 =27.955%

136 FINANCIAL MANAGEMENT
TRY IT! DIVIDENDS
Consider a company with the following information for the ﬁscal year:
Dividends paid $2 million
Net income $5 million
Number of shares outstanding 1 million
The company has no preferred stock outstanding. Complete the
following:
Dividends per share
Dividend payout ratio
Retention ratio
Dividend Reinvestment Plans

Many U.S. corporations allow shareholders to reinvest automatically their
dividends in the shares of the corporation paying them. A dividend reinvest-
ment plan (DRP or DRIP) is a program that allows shareholders to reinvest
their dividends, buying additional shares of stock of the company instead ofreceiving the cash dividend. A DRP offers beneﬁts to both shareholders and
the corporation:

1.Shareholders buy shares without transactions costs—brokers’commissions—and at a discount from the current market price.
2.The corporation retains cash without the cost of a new stock issue.
One stickler in all this, however, is that the dividends are taxed as in-
come before they are reinvested, even though the shareholders never see
the dividend. The result is similar to a dividend cut, but with a tax conse-

quence for the shareholders: The cash ﬂow that would have been paid toshareholders is plowed back into the corporation.
Many corporations ﬁnd high rates of participation in DRPs. If so many
shareholders want to reinvest their dividends—even after considering thetax consequences—why is the corporation paying dividends? This suggests

Dividend and Dividend Policies 137
that there is some rationale, such as signaling, that compels corporations to
pay dividends.
STOCK DISTRIBUTIONS
In addition to cash dividends, a corporation may provide shareholders with
dividends in the form of additional shares of stock or, rarely, some types

of property owned by the corporation. When dividends are not in cash,they are usually additional shares of stock. Additional shares of stock can
be distributed to shareholders in two ways: paying a stock dividend and
splitting the stock.
Types of Distributions
Astock dividend is the distribution of additional shares of stock to share-
holders. Stock dividends are generally stated as a percentage of existing
share holdings. If a corporation pays a stock dividend, it is not transferring

anything of value to the shareholders. The assets of the corporation remainthe same and each shareholder’s proportionate share of ownership remains
the same. All the corporation is doing is cutting its equity “pie” into more
slices and at the same time cutting each shareholder’s portion of that equity
into more slices. So why pay a stock dividend?
A stock split is something like a stock dividend. A stock split splits

the number of existing shares into more shares. For example, in a 2:1split—referred to as “two for one”—each shareholder gets two shares for
every one owned. If an investor owns 1,000 shares and the stock is split 2:1,the investor then owns 2,000 shares after the split. Has the portion of the
investor’s ownership in the company changed? No, the investor now simply

owns twice as many shares—and so does every other shareholder. If theinvestor owned 1% of the corporation’s stock before the split, the investor
still owns 1% after the split.
Areverse stock split is similar to a stock split, but backwards: a 1:2
reverse stock split reduces the number of shares of stock such that a share-holder receives half the number of shares held before the reverse stock split.

A stock split in which more shares are distributed to shareholders is some-times referred to as a forward stock split to distinguish it from a reverse
stock split. Similar to both the stock dividend and the stock split, there is noactual distribution or contribution made, but simply a division of the equitypie—in this case, into fewer pieces.

138 FINANCIAL MANAGEMENT
Stock distributions, similar to cash dividends, are a decision of the board
of directors, but in this case the “payment” date is similar when the addi-
tional shares are provided to shareholders, or shares exchanged, in the case
of a forward or a reverse stock split.
Reasons for Stock Distributions

There are a couple of reasons for paying dividends in the form of stock
dividends. One is to provide information to the market. A company may
want to communicate good news to the shareholders without paying cash.
For example, if the corporation has an attractive investment opportunityand needs funds for it, paying a cash dividend doesn’t make any sense—so
the corporation pays a stock dividend instead. But is this an effective way

of communicating good news to the shareholders? It costs very little to
pay a stock dividend—just minor expenses for recordkeeping, printing, and
distribution. But if it costs very little, do investors really trust it as a signal?
Another reason given for paying a stock dividend is to reduce the price

of the stock. If the price of a stock is high relative to most other stocks,there may be higher costs related to investors’ transactions of the stock, asin a higher broker’s commission. By paying a stock dividend—which slices
the equity pie into more pieces—the price of the stock should decline. Let’s
see how this works. Suppose an investor owns 1,000 shares, each worth$50 per share, for a total investment of $50,000. If the corporation pays

the investor a 5% stock dividend, the investor then owns 1,050 shares after
the dividend. Is there is any reason for your holdings to change in value?Nothing economic has gone on here—the company has the same assets,
the same liabilities, and the same equity—total equity is just cut up into
smaller pieces. There is no reason for the value of the portion of the equitythis investor owns to change. But the price per share should decline: from

$50 per share to $47.62 per share. The argument for reducing the share
price only works if the market brings down the price substantially, from
an unattractive trading range to a more attractive trading range in terms of
reducing brokerage commissions and enabling small investors to purchaseeven lots of 100 shares.
So why split? Like a stock dividend, the split reduces the trading price

of shares. If an investor owns 1,000 shares of the stock trading for $50 pershare prior to a 2:1 split, the shares should trade for $25 per share after
the split.
Aside from a minor difference in accounting, stock splits and stock divi-
dends are essentially the same. The stock dividend requires a shift within thestockholders’ equity accounts, from retained earnings to paid-in capital, for

Dividend and Dividend Policies 139
the amount of the distribution; the stock split requires only a memorandum
entry. A 2:1 split has the same effect on a stock’s price as a 100% stockdividend, a 1.5 to 1 split has the same effect on a stock’s price as a 50%
stock dividend, and so on. The basis of the accounting rules is related to the

reasons behind the distribution of additional shares. If companies want tobring down their share price, they tend to declare a stock split; if companies
want to communicate news, they often declare a stock dividend.
Companies tend to reverse stock split when the stock’s price is extremely
low, so low that they are at risk of being delisted from an exchange.
2Al o w
stock price is a function of how many shares are outstanding, but mostly a

function of poor performance which has led to a low share price.
How can investors tell what the motivation is behind stock dividends
and splits? They cannot, but they can get a general idea of how investorsinterpret these actions by looking at what happens to the corporation’s share
price when a corporation announces its decision to pay a stock dividend or

split its stock, or reverse split. If the share price tends to go up when theannouncement is made, the decision is probably good news; if the price tends
to go down, the stock dividend is probably bad news. This is supported by
evidence that indicates corporation’s earnings tend to increase followingstock splits and dividends.
3
The share price of companies announcing stock distributions and for-

ward stock splits generally increase at the time of the announcement. Thestock price typically increases by 1% to 2% when the split or stock dividend
is announced. When the stock dividend is distributed or the split is effected
(on the ex-date), the share’s price typically declines according to the amountof the distribution. Suppose a company announces a 2:1 split. Its share price
may increase by 1% to 2% when this is announced, but when the shares are

split, the share price will go down to approximately half of its presplit value.The most likely explanation is that this distribution is interpreted as good
news—that management believes that the future prospects of the company
are favorable or that the share price is more attractive to investors. We pro-
vide an example of a forward and a reverse stock split in Exhibit 7.2, using

the splits and stock prices of Sun Microsystems to illustrate the price effects.As you can see in this example, the adjustment of the price is close to—but
not precisely—the adjustment we expect on the basis of the amount of
the split.
2A reverse stock split, especially those such as 1:300 or 1:1,000, may also be used to
reduce the number of shareholders, and hence take the company private.
3See, for example, Maureen McNichols and Ajay Dravid, “Stock Dividends, Stock

Splits, and Signaling,” Journal of Finance 45, no. 3 (1990): 857–879.

140 FINANCIAL MANAGEMENT
EXHIBIT 7.2 Sun Microsystems Forward and Reverse
Sun Microsystems (ticker: JAVA) has declared numerous stock splits throughout its
history, but also declared a reverse stock split. Consider two splits:
Forward split December 6, 2000 2:1
Reverse split November 12, 2007 1:4
The price of Sun Microsystems before and after each split:
Two Days

Two Days
Before Day Before Split Day Day AfterTwo Days
After
Forward $78.88 $91.75 $44.25 $42.81 $38.94
Reverse $5.30 $5.14 $20.51 $21.38 $21.60
The price does not adjust solely by the split because of the inﬂuence of other market
and economic events, but the adjustment is very close: the stock price is almost1/2
that of the presplit for the 2:1 split, and the stock price is slightly more than 4 times
that presplit for the 1:4 split.
TRY IT! SPLITS AND DIVIDENDS

For each of the following cases, which is the expected share price
post-split or stock dividend?
CasePre-
DistributionPrice Per
ShareNumberof Shares
OutstandingPre-
DistributionDistri-bution TypeExpected
Price Per
ShareNumber
of Shares
Outstanding
Post-Splitor Stock
Dividend
A $50 1 million 2:1 Forward
split
B $20 1.5 million 1.5:1 Forward
split
C $5 10 million 1:5 Reverse split
D $40 1 million 25% Stock
dividend

Dividend and Dividend Policies 141
DIVIDEND POLICIES
Adividend policy is a corporation’s decision about the payment of cash
dividends to shareholders. There are several basic ways of describing a
corporation’s dividend policy:
■No dividends.
■Constant growth in dividends per share.
■Constant payout ratio.
■Low regular dividends with periodic extra dividends.

The corporations that typically do not pay dividends are those that
are generally viewed as younger, faster growing companies. For example,
Microsoft Corporation was founded in 1975 and went public in 1986, but
it did not pay a cash dividend until January 2003.
A common pattern of cash dividends tends to be the constant growth of
dividends per share. Another pattern is the constant payout ratio. Manyother companies in the food processing industry, such as Kellogg and

Tootsie Roll Industries, pay dividends that are a relatively constant percent-
age of earnings. Some companies display both a constant dividend payoutratio and a constant growth in dividends. This type of dividend pattern
is characteristic of large, mature companies that have predictable earnings
growth—the dividends growth tends to mimic the earnings growth, resultingin a constant payout.
U.S. corporations that pay dividends tend to pay either constant or in-

creasing dividends per share. Dividends tend to be lower in industries thathave many proﬁtable opportunities to invest their earnings. But as a com-
pany matures and ﬁnds fewer and fewer proﬁtable investment opportunities,
it generally pays out a greater portion of its earnings in dividends.
Many corporations are reluctant to cut dividends because the corpo-

ration’s share price usually falls when a dividend reduction is announced.For example, the U.S. auto manufacturers cut dividends during the recessionin the early 1990s. As earnings per share declined the automakers did not
cut dividends until earnings per share were negative—and in the case of
General Motors, not until it had experienced two consecutive loss years. Butas earnings recovered in the mid-1990s, dividends were increased.
4

4
Because investors tend to penalize companies that cut dividends, cor-
porations tend to only raise their regular quarterly dividend when they are
sure they can keep it up in the future. By giving a special or extra dividend,
4General Motors increased dividends until cutting them once again in 2006 as it
incurred substantial losses.

142 FINANCIAL MANAGEMENT
Freeport-McMoran (/g415cker: FCX) is a copper and gold mining company.
The company pays regular cash dividends in January, March, July, andOctober each year. The company also pays a supplemental dividendduring periods of higher proﬁts: Cash Dividend
Month
EXHIBIT 7.3 Extra Special Dividends
Data source: Freeport-McMoran Investor Center, Dividends.

the corporation is able to provide more cash to the shareholders withoutcommitting itself to paying an increased dividend each period into the fu-ture. We provide an example of special dividends in Exhibit 7.3 for the case
of Freeport-McMoran, which paid special dividends, which it referred to as
supplemental dividends in 2005 and 2006.
There is no general agreement whether dividends should or should not
be paid. Here are several views:

■The dividend irrelevance theory. The payment of dividends does not
affect the value of the company since the investment decision is inde-pendent of the ﬁnancing decision.
■The “bird in the hand” theory. Investors prefer a certain dividend stream
to an uncertain price appreciation.
■The tax-preference explanation. Due to the way in which dividends are
taxed, investors should prefer the retention of funds to the payment ofdividends.

Dividend and Dividend Policies 143
■The signaling explanation. Dividends provide a way for the management
to inform investors about the company’s future prospects.
■The agency explanation. The payment of dividends forces the company
to seek more external ﬁnancing, which subjects the company to the
scrutiny of investors.
The Dividend Irrelevance Theory

The dividend irrelevance argument was developed by Merton Miller and
Franco Modigliani.5Basically, the argument is that if there is a perfect
capital market —no taxes, no transactions costs, no costs related to issuing
new securities, and no costs of sending or receiving information—the valueof the corporation is unaffected by payment of dividends.
How can this be? Suppose investment decisions are ﬁxed—that is, the

company will invest in certain projects regardless how they are ﬁnanced.The value of the corporation is the present value of all future cash ﬂows ofthe company—which depend on the investment decisions that management
makes, noton how these investments are ﬁnanced. If the investment decision
is ﬁxed, whether a corporation pays a dividend or not does not affect the
value of the corporation.
A corporation raises additional funds either through earnings or by

selling securities—sufﬁcient to meet its investment decisions and its divi-
dend decision. The dividend decision therefore affects only the ﬁnancing
decision—how much capital the company has to raise to fulﬁll its invest-ment decisions.
The Miller and Modigliani argument implies that the dividend decision
is a residual decision: If the company has no proﬁtable investments to under-take, the company can pay out funds that would have gone to investments

to shareholders. And whether or not the company pays dividends is of no
consequence to the value of the company. In other words, dividends areirrelevant.
But companies don’t exist in a perfect world with a perfect capital
market. Are the imperfections (taxes, transactions costs, etc.) enough toalter the conclusions of Miller and Modigliani? It isn’t clear.
The “Bird in the Hand” Theory
A popular view is that dividends represent a sure thing relative to share

price appreciation. The return to shareholders is comprised of two parts: the
5Merton Miller and Franco Modigliani, “Dividend Policy, Growth and the Valuation
of Shares,” Journal of Business 34 (1961): 411–433.

144 FINANCIAL MANAGEMENT
return from dividends—the dividend yield —and the return from the change
in the share price—the capital yield. Corporations generate earnings and
can either pay them out in cash dividends or reinvest earnings in proﬁtable
investments, increasing the value of the stock and, hence, share price.
Once a dividend is paid, it is a certain cash ﬂow. Shareholders can

cash their quarterly dividend checks and reinvest the funds. But an increasein share price is not a sure thing. It only becomes a sure thing when the
share’s price increases over the price the shareholder paid and he or she sells
the shares.
We can observe that prices of dividend-paying stocks are less volatile

than nondividend-paying stocks. But are dividend-paying stocks less riskybecause they pay dividends? Or are less risky companies more likely to paydividends? Most of the evidence supports the latter. Companies that have
greater risk—business risk, ﬁnancial risk, or both—tend to pay little or no
dividends. In other words, companies whose cash ﬂows are more variabletend to avoid large dividend commitments that they could not satisfy during
periods of poorer ﬁnancial performance.

A bird in the hand’s worth two ﬂeeing by.
—Scottish proverb
The Tax-Preference Explanation
If dividend income is taxed at the same rates as capital gain income, investorsmay prefer capital gains because of the time value of money: capital gains are
only taxed when realized—that is, when the investor sells the stock—whereasdividend income is taxed when received. If, on the other hand, dividend

income is taxed at rates higher than that applied to capital gain income,
investors should prefer stock price appreciation to dividend income because
of both the time value of money and the lower rates.
Historically, capital gain income in the United States has been taxed at
rates lower than that applied to dividend income for individual investors.However, the current situation for individuals is that dividend income and

capital gain income are taxed at the same rates. Even with the same ratesapplied to income, capital gain income is still preferred because the tax on
any stock appreciation is deferred until the stock is sold—which can be many
years into the future.
But the tax impact is different for different types of shareholders. A
corporation receiving a dividend from another corporation may take a

Dividend and Dividend Policies 145
dividends received deduction —a deduction of a large portion of the divi-
dend income.6The dividends received deduction ranges from 70% to 100%,
depending on the ownership relation between the two corporations. There-
fore, corporations pay taxes on a small portion of their dividend income,

mitigating some, and perhaps all of double taxation on corporate income
distributed to other corporations. Still other shareholders may not even betaxed on dividend income. For example, a pension fund beneﬁciary does
not pay taxes on the dividend income it gets from its investments (these
earnings are eventually taxed when the pension is paid out to the employeeafter retirement).
Even if dividend income were taxed at rates higher than that of capi-

tal gains, investors could take investment actions that affect this difference.First, investors that have high marginal tax rates may gravitate toward
stocks that pay little or no dividends. This means the shareholders of divi-
dend paying stocks have lower marginal tax rates. This is referred to as a tax
clientele—investors who choose stocks on the basis of the taxes they have
to pay. Second, investors with high marginal tax rates can use legitimate

investment strategies—such as borrowing to buy stock and using the deduc-
tion from the interest payments on the loan to offset the dividend income in
order to reduce the tax impact of dividends.
The Signaling Explanation
Companies that pay dividends seem to maintain a relatively stable dividend,either in terms of a constant or growing dividend payout ratio or in terms ofa constant or growing dividend per share. And when companies change their

dividend—either increasing or reducing (“cutting”) the dividend—the price
of the company’s shares seems to be affected: When a dividend is increased,the price of the company’s shares typically goes up; when a dividend is
cut, the price usually goes down. This reaction is attributed to investors’
perception of the meaning of the dividend change: Increases are good news,decreases are bad news.
The board of directors is likely to have some information that investors

do not have, a change in dividend may be a way for the board to signal this
private information. Because most boards of directors are aware that when
dividends are lowered, the price of a share usually falls, most investors donot expect boards to increase a dividend unless they thought the company
6In other words, the dividends are included in income, but then the receiving corpo-
ration takes a large deduction.

146 FINANCIAL MANAGEMENT
could maintain it into the future. Realizing this, investors may view a div-
idend increase as the board’s increased conﬁdence in the future operatingperformance of the company.
The Agency Explanation

The relation between the owners and the managers of a company is an agencyrelationship: The owners are the principals and the managers are the agents.Management is charged with acting in the best interests of the owners.
Nevertheless, there are possibilities for conﬂicts between the interests of
the two.
If the company pays a dividend, the company may be forced to raise

new capital outside of the company—that is, issue new securities insteadof using internally generated capital—subjecting them to the scrutiny of
equity research analysts and other investors. This extra scrutiny helps re-
duce the possibility that managers will not work in the best interests ofthe shareholders. But issuing new securities is not costless. There are costs
of issuing new securities—ﬂotation costs. In “agency theory-speak,” these

costs are part of monitoring costs—incurred to help monitor the man-agers’ behavior and insure behavior is consistent with shareholder wealth
maximization.
The payment of dividends also reduces the amount of free cash ﬂow un-
der control of management. Free cash ﬂow is the cash in excess of the cash
needed to ﬁnance proﬁtable investment opportunities. A proﬁtable invest-

ment opportunity is any investment that provides the company with a returngreater than what shareholders could get elsewhere on their money—that is,
a return greater than the shareholders’ opportunity cost.
Because free cash ﬂow is the cash ﬂow left over after all proﬁtable
projects are undertaken, the only projects left are the unproﬁtable ones.Should free cash be reinvested in the unproﬁtable investments or paid
out to shareholders? Of course if boards make decisions consistent with

shareholder wealth maximization, any free cash ﬂow should be paid
out to shareholders since—by the deﬁnition of a proﬁtable investmentopportunity—the shareholders could get a better return investing the funds
they receive.
If the company pays a dividend, funds are paid out to shareholders.
If the company needs additional funds, it could be raised by issuing newsecurities; in this event, shareholders wishing to reinvest the funds received

as dividends in the company could buy these new securities. One view of therole of dividends is that the payment of dividends therefore reduces the cash
ﬂow in the hands of management, reducing the possibility that managers
will invest funds in unproﬁtable investment opportunities.

Dividend and Dividend Policies 147
To Pay or Not to Pay Dividends
We can ﬁgure out reasons why a company should or should not pay divi-
dends, but not why they actually do or do not—this is the “dividend puzzle”
coined by Fischer Black.7But we do know from looking at dividends and
the market’s reaction to dividend actions that:

■If a company increases its dividends or pays a dividend for the ﬁrst time,
this is viewed as good news—its share price increases.
■If a company decreases its dividend or omits it completely, this is viewedas bad news—its share price declines.
That is why corporations must be aware of the relation between divi-
dends and the value of the common stock in establishing or changing divi-
dend policy.
STOCK REPURCHASES

Corporations have repurchased their common stock from their sharehold-
ers. A corporation repurchasing its own shares is effectively paying a cash
dividend, with one important difference: taxes. Cash dividends are ordinary
taxable income to the shareholder. A company’s repurchase of shares, onthe other hand, results in a capital gain or loss for the shareholder, depend-
ing on the price paid when they were originally purchased. If the shares are

repurchased at a higher price, the difference may be taxed as capital gains,which may be taxed at rates lower than ordinary income.
Methods of Repurchasing Stock
The company may repurchase its own stock by any of three methods: (1) atender offer, (2) open market purchases, and (3) a targeted block repurchase.
Atender offer is an offer made to all shareholders, with a speciﬁed deadline
and a speciﬁed number of shares the corporation is willing to buy back.

The tender offer may be a ﬁxed price offer, where the corporation speciﬁes
the price it is willing to pay and solicits purchases of shares of stock at
that price.
7Fischer Black, “The Dividend Puzzle,” Journal of Portfolio Management 2 (1976):
5–8.

148 FINANCIAL MANAGEMENT
A tender offer may also be conducted as a Dutch auction in which
the corporation speciﬁes a minimum and a maximum price, soliciting bids
from shareholders for any price within this range at which they are willingto sell their shares. After the corporation receives these bids, they pay all
tendering shareholders the maximum price sufﬁcient to buy back the number

of shares they want. A Dutch auction reduces the chance that the companypays a price higher than needed to acquire the shares. Dutch auctions are
gaining in popularity relative to ﬁxed-price offers.
Biogen, a biotechnology company, announced a Dutch auction tender
offer in May 2007 for shares of its common stock. In Exhibit 7.4, the offerwas for up to 57 million shares of stock, at a price not less than $47 per

share and not more than $53 per share. Biogen accepted 56,424,155 sharesat $53 per share, or 16.4% of its shares outstanding at the time of the offer.
A corporation may also buy back shares directly in the open market.
This involves buying the shares through a broker. A corporation that wantsto buy shares may have to spread its purchases over time so as not to drive
the share’s price up temporarily by buying large numbers of shares.

The third method of repurchasing stock is to buy it from a speciﬁc
shareholder. This involves direct negotiation between the corporation and
the shareholder. This method is referred to as a targeted block repurchase ,
since there is a speciﬁc shareholder (the “target”) and there are a large
number of shares (a “block”) to be purchased at one time. Targeted block
repurchases, also referred to as “greenmail,” were used in the 1980s to ﬁghtcorporate takeovers.
Reasons to Repurchase Stock

Corporations repurchase their stock for a number of reasons. First, a re-purchase is a way to distribute cash to shareholders at a lower cost to both
the company and the shareholders than dividends. If capital gains are taxed
at rates lower than ordinary income, which until recently has been the case
with U.S. tax law, repurchasing is a lower cost way of distributing cash.

However, since shareholders have different tax rates—especially when com-paring corporate shareholders with individual shareholders—the beneﬁt is
mixed. The reason is that some shareholders’ income is tax-free (e.g., pen-
sion funds), some shareholders are only taxed on a portion of dividends(e.g., corporations receiving dividends from other corporations), and some
shareholders are taxed on the full amount of dividends (e.g., individual
taxpayers).

Another reason to repurchase stock is to increase earnings per share. A
company that repurchases its shares increases its earnings per share simply

Dividend and Dividend Policies 149
because there are fewer shares outstanding after the repurchase. But there
are two problems with this motive. First, cash is paid to the shareholders,so less cash is available for the corporation to reinvest in proﬁtable projects.
Second, because there are fewer shares, the earnings pie is sliced in fewer

pieces, resulting in higher earnings per share. The individual “slices” arebigger, but the pie itself remains the same size.
Looking at how share prices respond to gimmicks that manipulate earn-
ings, there is evidence that a company cannot fool the market by playingan earnings-per-share game. The market can see through the earnings per
share to what is really happening and that the company will have less cash
to invest.
Still another reason for stock repurchase is that it could tilt the debt-

equity ratio so as to increase the value of the company. By buying backstock—thereby reducing equity—the company’s assets are ﬁnanced to a
greater degree by debt. Does this seem wrong? It’s not. To see this, suppose
a corporation has a balance sheet consisting of assets of $100 million, lia-bilities of $50 million, and $50 million of equity. That is, the corporation
has ﬁnanced 50% of its assets with debt, and 50% with equity. If this cor-

poration uses $20 million of its assets to buy back stock worth $20 million,its balance sheet will have assets of $80 million ﬁnanced by $50 million of
liabilities and $30 million of equity. It now ﬁnances 62.5% of its assets with
debt and 37.5% with equity.
If ﬁnancing the company with more debt is good—that is, the beneﬁts

from deducting interest on debt outweigh the cost of increasing the risk ofbankruptcy—repurchasing stock may increase the value of the company.But there is the ﬂip-side to this argument: Financing the company with
more debt may be bad if the risk of ﬁnancial distress—difﬁculty paying legal
obligations—outweighs the beneﬁts from tax deductibility of interest. So,repurchasing shares from this perspective would have to be judged on a

case-by-case basis to determine if it’s beneﬁcial or detrimental.
One more reason for a stock repurchase is that it reduces total dividend
payments—without seeming to. If the corporation cuts down on the number
of shares outstanding, the corporation can still pay the same amount ofdividends per share, but the total dividend payments are reduced. If the

shares are correctly valued in the market (there is no reason to believeotherwise), the payment for the repurchased shares equals the reduction inthe value of the company—and the remaining shares are worth the same as
they were before.
Some argue that a repurchase is a signal about future prospects. That is,
by buying back the shares, the management is communicating to investorsthat the company is generating sufﬁcient cash to be able to buy back shares.

150 FINANCIAL MANAGEMENT
But does this make sense? Not really. If the company has proﬁtable invest-
ment opportunities, the cash could be used to ﬁnance these investments,instead of paying it out to the shareholders.
A stock repurchase may also reduce agency costs by reducing the amount

of cash the management has on hand. Similar to the argument suggested fordividend payments, repurchasing shares reduces the amount of free cash
ﬂow and, therefore, reduces the possibility that management will invest
it unproﬁtably. Many companies use stock buybacks to mitigate the dilu-tion resulting from executive stock options, as well as to shore up their
stock price.
Repurchasing shares tends to shrink the company: Cash is paid out and

the value of the company is smaller. Can repurchasing shares be consistentwith wealth maximization? Yes. If the best use of funds is to pay them
out to shareholders, repurchasing shares maximizes shareholders’ wealth. If
the company has no proﬁtable investment opportunities, it is better for a
company to shrink by paying funds to the shareholders than to shrink byinvesting in lousy investments.
So how does the market react to a company’s intention to repurchase

shares? A number of studies have looked at how the market reacts to suchannouncements. In general, the share price goes up when a company an-
nounces it is going to repurchase its own shares. It is difﬁcult to iden-
tify the reason the market reacts favorably to such announcements sinceso many other things are happening at the same time. By piecing bits
of evidence together, however, we see that it is likely that investors view

the announcement of a repurchase as good news—a signal of good thingsto come.
■Companies may distribute funds to owners in the form of periodic cash
dividends. A company’s board of directors decides on the amount and
timing of dividends.
■Companies may make stock dividends or split the stock. Though not
an event that results in any economic value to owners, investors often

interpret the decision to pay a stock dividend or to split the stock asconveying information about the company’s future prospects.
■There are several theories related to why companies pay dividends,including the dividend irrelevance theory, the bird-in-the-hand theory,the tax-preference theory, signaling theory, and agency theory.

Dividend and Dividend Policies 151
■As an alternative to paying dividends, a company may choose to dis-
tribute funds to shareholders by repurchasing its own stock from share-holders, either through a tender offer, open market purchases, or a block
repurchase.
Dividends
Dividends per share $2
Earnings per share $5
Dividend payout ratio 40%
Retention ratio 60%

Stock Distributions
CaseExpected Price Per Share
Post-DistributionNumber of Shares Outstanding
Post-Distribution
A $25.00 2 million
B $13.33 2.25 million
C $25.00 2 million
D $32.00 1.25 million
QUESTIONS
1.Distinguish between the dividend payout ratio and the dividend per
share.
2.If a company has a dividend payout ratio of 80%, what is the company’s
retention ratio?
3.If a company has a dividend per share of $2 and earnings per share of

$8, which is the company’s dividend payout ratio?
4.What are the beneﬁts from the perspective of a shareholder of a dividendreinvestment plan?
5.What is the difference between a stock dividend and a stock split?
6.Why would a company want to use a reverse stock split?
7.If a company splits its stock, what is the expected effect on the stock’sshare price?

152 FINANCIAL MANAGEMENT
8.Why might a company “pay” as a stock dividend?
9.List the three possible explanations for why companies pay cash divi-
dends.
10.Identify three different methods that a company can use to repurchaseits own stock from investors.
11.Complete the following table:
StockPrice Per
Share
Before
DistributionNumber of
Shares
Before the

Shares
Before the
Distribution DistributionExpected
Price Per
Share
After the
Shares
After the
Distribution
ABC $20 1 million 2:1DEF $40 0.5 million 1:5
GHI $25 2 million 2.5:1
12.Suppose a company with net income of $200 million and 3 million
shares outstanding pays $50 million in cash dividends.
a.What is the dividend payout ratio?
b.What is the dividend per share?

13.If a company’s stock has a dividend per share of $2 and earnings pershare of $5, what is the company’s retention ratio?
14.The following is from the 2008 Annual Report of Philips Company re-
garding its dividend policy (www.annualreport2008.philips.com/pages/
investor
information/dividend policy.asp)
Our aim is to sustainably grow our dividend over time. Philips’

present dividend policy is based on an annual pay-out ratio of40 to 50% of continuing net income.
What does this mean?
15.The following excerpts are taken from “Dividend Policy Determinants:
An Investigation of the Inﬂuences of Stakeholder Theory” by Mark E.
Holder, Frederick W. Langrehr, and J. Lawrence Hexter, published in
the Autumn 1998 issue of Financial Management :
There is considerable debate on how dividend policy affectsﬁrm value. Some researchers believe that dividends increase

shareholder wealth ..., others believe that dividends are irrele-
vant..., and still others believe that dividends decrease share-
holder wealth.

Dividend and Dividend Policies 153
a.What are the arguments in support of the dividend policy increasing
shareholder wealth?
b.What are the arguments in support of the irrelevance of dividend
policy?
c.What are the arguments in support of the dividend policy decreasing
One group of ﬁnancial theorists ...provides a hypothesis for

dividend policy irrelevance. This group bases its theory on the
assumptions of 1) perfect capital markets ...; 2) rational behav-
ior on the part of participants in the market, valuing securities
based on the discounted value of future cash ﬂows accruing to
investors; 3) certainty about the investment policy of the ﬁrm
and complete knowledge of these cash ﬂows; and 4) managers
that act as perfect agents of the shareholders.
d.What is meant by a perfect capital market?

e.What is assumed about the company’s investment policy?
f.What is meant by “managers that act as perfect agents of the share-
holders”?

154

c08 JWBT310-Fabozzi July 1, 2010 13:3 Printer: Courier Westford, Westford, MA
CHAPTER8
The Corporate Financing Decision
How much does the company owe, and how much does it own?
Debt versus equity. It’s just the kind of thing a loan ofﬁcer would
want to know about you in deciding if you are a good credit risk.
A normal corporate balance sheet has two sides. On the left side

are the assets (inventories, receivables, plant and equipment, etc.).The right side shows how the assets are ﬁnanced. One quick way
to determine the ﬁnancial strength of a company is to compare theequity to the debt on the right side of the balance sheet.
—Peter Lynch with John Rothchild, One Up on Wall Street
(New York: Penguin Books, 1989), p. 201
Abusiness invests in new plant and equipment to generate additional rev-enues and income—the basis for its growth. One way to pay for in-

vestments is to generate capital from the company’s operations. Earningsgenerated by the company belong to the owners and can either be paid tothem—in the form of cash dividends—or plowed back into the company.
The owners’ investment in the company is referred to as owners’ eq-
uityor, simply, equity. If earnings are plowed back into the company, the
owners expect it to be invested in projects that will enhance the value of
the company and, hence, enhance the value of their equity. But earnings

may not be sufﬁcient to support all proﬁtable investment opportunities. Inthat case management is faced with a decision: Forego proﬁtable investment
opportunities or raise additional capital. New capital can be raised by either
borrowing or selling additional ownership interests or both. We refer to themix of debt and equity that a company uses as its capital structure.
The decision about how the company should be ﬁnanced, whether with

debt or equity, is referred to as the capital structure decision . In this chap-
ter, we discuss the capital structure decision. There are different theories
155

156 FINANCIAL MANAGEMENT
about how the company should be ﬁnanced and we review these theories in
this chapter.
DEBT VS. EQUITY
The capital structure of a company is some mix of the three sources of
capital: debt, internally generated equity, and new equity. But what is the

right mixture? The best capital structure depends on several factors. If acompany ﬁnances its activities with debt, the creditors expect the interest
and principal—ﬁxed, legal commitments—to be paid back as promised.
Failure to pay may result in legal actions by the creditors. If the companyﬁnances its activities with equity, the owners expect a return in terms of cash
dividends, an appreciation of the value of the equity interest or, as is most
likely, some combination of both.

Suppose a company borrows $100 million and promises to repay the
$100 million plus $5 million in one year. Consider what may happen whenthe $100 is invested:
So, if the company reinvests the funds and generates more than the
$100 million +$5 million =$105 million, the company keeps all the proﬁts.
But if the project generates $105 million or less, the lender still gets her or
his $5 million—but there is nothing left for the company’s owners. This is

the basic idea behind ﬁnancial leverage—the use of ﬁnancing that has ﬁxed,
but limited payments.
If the company has abundant earnings, the owners reap all that remains
of the earnings after the creditors have been paid. If earnings are low, the

The Corporate Financing Decision 157
creditors still must be paid what they are due, leaving the owners nothing
out of the earnings. Failure to pay interest or principal as promised mayresult in ﬁnancial distress. Financial distress is the condition where a com-

pany makes decisions under pressure to satisfy its legal obligations to itscreditors. These decisions may not be in the best interests of the owners ofthe company.
With equity ﬁnancing there is no obligation. Though the company may
choose to distribute funds to the owners in the form of cash dividends,there is no legal requirement to do so. Furthermore, interest paid on debt
is deductible for tax purposes, whereas dividend payments are not tax de-
ductible.

ductible.
One measure of the extent debt is used to ﬁnance a company is the debt
ratio, the ratio of debt to equity:
Debt ratio =Debt
Equity
This is relative measure of debt to equity. The greater the debt ratio, the
greater is the use of debt for ﬁnancing operations relative to equity ﬁnancing.Another measure is the debt-to-assets ratio, which is the extent to which the
assets of the company are ﬁnanced with debt:
Debt-to-assets ratio =Debt
Total assets

This is the proportion of debt in a company’s capital structure, measured
using the book, or carrying value of the debt and assets.
It is often useful to focus on the long-term capital of a company when
evaluating the capital structure of a company, looking at the interest-bearing
debt of the company in comparison with the company’s equity or with its
capital. The capital of a company is the sum of its interest-bearing debt and

its equity. The debt ratio can be restated as the ratio of the interest-bearing
debt of the company to the company’s equity:
Debt-equity ratio =Interest-bearing debt
Equity
and the debt-to-assets can be restated as the proportion of interest-bearingdebt of the company’s capital:
Total capital

158 FINANCIAL MANAGEMENT
By focusing on the long-term capital, the working capital decisions of a
company that affect current liabilities such as accounts payable, are removed
from this analysis.
The equity component of all of these ratios is often stated in book, or

carrying value terms. However, when taking a markets perspective of thecompany’s capital structure, it is often useful to compare debt capital with
the market value of equity. In this latter formulation, for example, the total
capital of the company is the sum of the market value of interest-bearingdebt and the market value of equity.
If market values of debt and equity are the most useful for decision-

making, should management ignore book values? No, because book val-ues are relevant in decision-making also. For example, bond covenants are
often speciﬁed in terms of book values or ratios of book values. As another
example, dividends are distinguished from the return of capital based on the
availability of the book value of retained earnings. Therefore, though the
focus is primarily on the market values of capital, management must alsokeep an eye on the book value of debt and equity as well.

There is a tendency for companies in some sectors and industries to use
more debt than others. We can make some generalizations about differencesin capital structures across sectors:
■Companies that are more reliant upon research and developmentfor new products and technology—for example, pharmaceuticalcompanies—tend to have lower debt-to-asset ratios than companies
without such research and development needs.
■Companies that require a relatively heavy investment in ﬁxed assets tend

to have lower debt-to-asset ratios.
Considering these generalizations and other observations related to dif-
fering capital structures, why do some industries tend to have companies
with higher debt ratios than other industries? By examining the role of ﬁ-
nancial leveraging, ﬁnancial distress, and taxes, we can explain some of the
variation in debt ratios among industries. And by analyzing these factors,
we can explain how the company’s value may be affected by its capital
structure.

Capital Structure and Financial Leverage
Debt and equity ﬁnancing create different types of obligations for the com-pany. Debt ﬁnancing obligates the company to pay creditors interest and
principal—usually a ﬁxed amount—when promised. If the company earns
more than necessary to meet its debt payments, it can either distribute the

The Corporate Financing Decision 159
surplus to the owners or reinvest. Equity ﬁnancing does not obligate the com-
pany to distribute earnings. The company may pay dividends or repurchasestock from the owners, but there is no obligation to do so.
Creditors have better memories than debtors.
The ﬁxed and limited nature of the debt obligation affects the risk of

the earnings to the owners. We illustrate the effect on earnings using three
different companies, each with a different capital structure:
■Company NL, with no debt
■Company L, with some debt
■Company LL, with lots of debt
Let’s assume that each company has $100 million in assets. Company
NL ﬁnances these assets completely with equity. Company L ﬁnances its
assets with 25% debt and 75% equity, while Company LL ﬁnances its
assets with 75% debt and 25% equity:

In Millions Company NL Company L Company LL
Assets $100 $100 $100
Debt $ 0 $ 25 $ 75
Equity $100 $ 75 $ 25
The leverage ratios of these companies are therefore:
Company NL Company L Company LL
Debt-equity 0% 33% 300%
Debt-to-assets 0% 25% 75%
Let’s further assume that the companies have identical operating earn-
ings, $10 million, and that any debt has an interest rate of 5%.1Operating

earnings are the income from the operations of the business (that is, revenuesless cost of goods sold and operating expenses), but before any outlays to the
1Assuming that the interest rate on debt is the same, no matter the leverage, this will
at least help illustrate the immediate issues.

160 FINANCIAL MANAGEMENT
providers of capital, such as interest on debt and dividends to owners. Let’s
also assume, for right now, that there are no taxes on income. Therefore,the net income of these companies is:
Operating earnings $10.00 $10.00 $10.00
Interest on debt 0.00 2.25 3.75
Net income $10.00 $ 8.75 $ 6.25

And the return on assets and return on equity for each are:
Return on assets 10.00% 8.75% 6.25%Return on equity 10.00% 11.67% 25.00%
The return on assets is the ratio of the company’s net income to its total
assets, whereas the return on equity is the ratio of the company’s net income
to owners’ equity.
Company LL has the highest return on equity, though the lowest return

on assets. This is because Company LL pays the higher interest on debt,which lowers net income and hence produces the lower return on assets, but
has the lowest amount of equity, so when the lower income is compared
to the lower shareholders’ equity, Company LL has the highest return toshareholders.
Now let’s assume that operating earnings are, instead, $4 million. In
this case:
Operating earnings $4.00 $4.00 $4.00
Interest on debt $0.00 $1.25 $3.75

Net income $4.00 $2.75 $0.25
And the returns are:
Return on assets 4.00% 2.75% 0.25%Return on equity 4.00% 3.67% 1.00%

The Corporate Financing Decision 161
In this case, Company LL has the lowest net income and the lowest
returns.
When you combine ignorance and leverage, you get some pretty
interesting results.
—Warren Buffett
This example illustrates the role of debt ﬁnancing on the risk associated
with earnings: the greater the use of debt vis- `a-vis equity, the greater the risk

associated with earnings to owners. Or, using the leverage terminology, thegreater the degree of ﬁnancial leverage, the greater the ﬁnancial risk. The
effect of ﬁnancial risk in addition to the operating risk magniﬁes the risk to
the owners.
Comparing the results of each of the three companies provides infor-

mation on the effects of using debt ﬁnancing. As more debt is used inthe capital structure, the greater the “swing” in returns, as we show inExhibit 8.1 for a range of operating earnings for Companies NL, L, and LL.
An interesting exercise is to see at which level of earnings the returns are
the same for two or more different types of ﬁnancing. In our example, whenoperating earnings are $5 million, the returns on equity for Company NL,
–60%–40%–20%0%20%40%60%

$2 ($1) ($4) ($7) ($10) $5 $8 $11 $14Return on Equity
Operating EarningsCompany NL
Company L
Company LL
EXHIBIT 8.1 Returns to Equity for Company NL, Company L, and Company
LL, Ignoring Taxes and Assuming Interest on Debt of 5%

162 FINANCIAL MANAGEMENT
Company L, and Company LL are the same at 5%. Therefore, the break-even
operating earnings for these companies—before we consider taxes and as-suming that the interest on debt is the same across companies—is $5 million.
TRY IT! RETURNS WITH LEVERAGE

Suppose we have another company, Company SL, that has the sameinterest rate on debt as Company L in our example. If we assume thatthere are no taxes, complete the following if Company SL has a capital
structure of $50 million debt and $50 equity:
In Millions
Operating earnings $5.00
Interest on debt
Net income
Return on assets
Return on equity
Interest Deductibility
In the United States, the interest a business pays on debt is deductible for

tax purposes. Because dividends paid on stock are not deductible, this de-ductibility of interest on debt provides a distinct advantage to using debt
because it effectively lowers the cost of this form of ﬁnancing.
Let’s continue our example, but now introduce taxes. Assuming that all
three companies pay taxes at a rate of 30% on taxable income, we see thatthis deductibility increases the net income of the companies ﬁnanced with

debt, relative to the no-tax case. If operating earnings are $10 million, then:
Operating earnings $10.00 $10.00 $10.00Interest on debt $ 0.00
$1 . 2 5 $3 . 7 5
Taxable income $10.00 $ 8.75 $ 6.25Taxes at 30% $ 3.00
$2 . 6 3 $1 . 8 8
Net income $ 7.00 $ 6.13 $ 4.38
Return on assets 7.00% 6.13% 4.38%
Return on equity 7.00% 8.17% 17.50%

The Corporate Financing Decision 163
And if operating earnings are $4 million, then:
Taxable income $4.00 $2.75 $0.25Taxes at 30% $1.20
$0.83 $0.08
Net income $2.80 $1.93 $0.18
Return on assets 2.80% 1.93% 0.18%Return on equity 2.80% 2.57% 0.70%

The deductibility of interest represents a form of a government subsidy
of ﬁnancing activities. By allowing interest to be deducted from taxableincome, the government is sharing the company’s cost of debt. Who beneﬁts
from this tax deductibility? The owners.
An interesting element introduced into the capital structure decision is
the reduction of taxes due to the payment of interest on debt. We refer tothe beneﬁt from interest deductibility as the interest tax shield ,because the

interest expense shields income from taxation. The tax shield from interest
deductibility is
Interest tax shield =Tax rate ×Interest expense
Company L has $25 million of 5% debt and is subject to a tax of 30%
on net income, the tax shield is
Tax shield =0.30 ($25 ×0.05) =0.30×$1.25=$0.375 million
A $1.25 million interest expense means that $1.25 million of income is
not taxed at 30%, saving the company $0.375 million. Company LL, withmore debt, has a tax shield of the following:

Tax shield =0.30 ($75 ×0.05) =0.30×$3.75=$1.125 million
Recognizing that the interest expense is the interest rate on the debt, r
d,
multiplied by the face value of debt the tax shield for a company is
Tax shield =Tax rate ×Interest rate ×Face value of debt
We should specify that the tax rate is the marginal tax rate —the tax rate
on the next dollar of income.

164 FINANCIAL MANAGEMENT
How does this tax shield affect the value of the company? The tax shield
reduces the net income of the company that goes to pay taxes. And because
management is concerned with how interest protects income from taxation,
the focus should be on how it shields taxable income beyond the income that

is shielded by all other tax deductible expenses. As long as the company canuse these tax shields—that is, it generates income that interest reduces—the
tax shield is valuable to owners.
TRY IT! RETURNS WITH LEVERAGE AND TAXES
Suppose we have another company, Company SL, that has the same
interest rate on debt as Company L in our example. If we assume a
tax rate of 30%, complete the following if Company SL has a capital

Taxable income
Taxes
Net income
FINANCIAL LEVERAGE AND RISK
The use of ﬁnancial leverage (that is, the use of debt in ﬁnancing a company)increases the range of possible outcomes for owners of the company. As
we saw previously, the use of debt ﬁnancing, relative to equity ﬁnancing,

increases both the upside and downside potential earnings for owners. Inother words, ﬁnancial leverage increases the risk to owners. Now that we
understand the basics of leverage, let’s quantify its effect on the risk of
earnings to owners.
Another way to view the choice of ﬁnancing is to calculate the degree of
ﬁnancial leverage, denoted by DFL, which is the ratio of operating earningsto earnings after deducting interest:
DFL=Operating earnings
Operating earnings −Interest

The Corporate Financing Decision 165
Calculating the DFL for the three companies at different levels of oper-
ating earnings, we see the differences in DFL among the three companies,
with Company LL having the highest degree of ﬁnancial leverage:
DFL Operating
Earnings in
Millions Company NL Company L Company LL
$4 1.00 1.45 16.00
$5 1.00 1.33 4.00
$6 1.00 1.26 2.67
$7 1.00 1.22 2.15

$8 1.00 1.19 1.88
$9 1.00 1.16 1.71
$10 1.00 1.14 1.60
The interpretation of the DFL is similar to any elasticity measure: If
the DFL is 4, this means a 1% change in operating earnings will produce a1%×4=4% change in earnings to owners.
Equity owners can reap most of the rewards through ﬁnancial leverage

when their company does well. But they may suffer a downside when thecompany does poorly. What happens if earnings are so low that it cannotcover interest payments? Interest must be paid no matter how low the earn-
ings. How does a company obtain money with which to pay interest when
earnings are insufﬁcient?
■By reducing the assets in some way, such as using working capital needed
for operations or selling buildings or equipment
■By taking on more debt obligations

■By issuing more shares of stock
Whichever the company chooses, the burden ultimately falls upon the
owners.
Leverage and Financial Flexibility
The use of debt also reduces a company’s ﬁnancial ﬂexibility. A company
with debt capacity that is unused, sometimes referred to as ﬁnancial slack,i s
more prepared to take advantage of investment opportunities in the future.
This ability to exploit these future, strategic options is valuable and, hence,

taking on debt increases the risk that the company may not be sufﬁcientlynimble to act on valuable opportunities.

166 FINANCIAL MANAGEMENT
There is evidence that suggests that companies that have more cash ﬂow
volatility tend to build up more ﬁnancial slack and, hence, their investments
are not as sensitive to their ability to generate cash ﬂows internally. Rather,
the ﬁnancial slack allows them to exploit investment opportunities without
relying on recent internally generated cash ﬂows.

In the context of the effect of leverage on risk, this means that companies
that tend to have highly volatile operating earnings may want to maintainsome level of ﬁnancial ﬂexibility by not taking on signiﬁcant leverage in theform of debt ﬁnancing.
Governance Value of Debt Financing
A company’s use of debt ﬁnancing may provide additional monitoring of a
company’s management and decisions, reducing agency costs. Agency costs

are the costs that arise from the separation of the management and theownership of a company, which is particularly acute in large corporations.
These costs are the costs necessary to resolve the agency problem that may
exist between management and ownership of the company and may includethe cost of monitoring company management. These costs include the costs
associated with the board of directors and providing ﬁnancial information
to shareholders and other investors.

An agency problem that may arise in a company is how effectively a
company uses its cash ﬂows. The free cash ﬂow of a company is, basically,its cash ﬂow less any capital expenditures and dividends. One theory that
has been widely regarded is that by using debt ﬁnancing, the company
reduces its free cash ﬂows and, therefore, it must reenter the debt marketto raise new capital.
2It is argued that this beneﬁts the company in two

ways. First, there are fewer resources under control of management and lesschance of wasting these resources in unproﬁtable investments. Second, thecontinual dependence of the debt market for capital imposes a monitoring
or governance discipline on the company that would not have been there
otherwise.
If we assume that there are no direct or indirect costs to ﬁnancial distress,

the cost of capital for the company should be the same, no matter the methodof ﬁnancing. If the operating earnings are $7.14 million, which produces areturn on equity of 5% for Company NL (that is, net income divided by
equity) and the cost of capital is 5%, the debt adds to the value of equity,
beneﬁtting owners, as we show in Exhibit 8.2.
2Michael C. Jensen, “Agency Cost of Free Cash Flow, Corporate Finance, and
Takeovers,” American Economic Review 76 (1986): 323–329.

The Corporate Financing Decision 167
EXHIBIT 8.2 Value Added by the Tax Deductibility of Debt
Operating income $7.14 $7.14 $7.14
Interest expense 0.00 1.25 3.75
Taxable income $7.14 $5.89 $3.39
Taxes at 30% 2.14 1.77 1.02
Income to owners $5.00 $4.13 $2.38
Income to the government $2.14 $1.77 $1.02
Income to creditors 0.00 1.25 3.75

Income to owners 5.00 4.13 2.38
Income to all $7.14 $7.14 $7.14
Value to creditors $0.00 $25.00 $75.00
Value to owners 100.00 82.50 47.50
Value of company $100.00 $107.50 $122.50
Capital contributed by:
Creditors $0.00 $25.00 $75.00
Owners 100.00 75.00 25.00
Total contributed capital $100.00 $100.00 $100.00
Value added by the tax
deductibility of debt$0.00 $7.50 $22.50
Return on equity 5.00% 5.50% 9.50%
A few notes about what we show in Exhibit 8.2:

1.The income to owners is less at this return on equity if the company has
more debt, but the capital contributed by owners is less if debt ﬁnancing
is used.
2.The income to the government is less as more debt is used because more
income is shielded from taxation.
3.The value to creditors is the face amount of the debt, whereas the value to
owners is today’s value of the income to owners, valued as a perpetuity

(that is, income divided by the cost of equity, 5%).
4.The owners reap the beneﬁts from the use of debt, with more value-
added as more debt is used.
5.The owners have a greater return on their investment, as measured bythe return on equity, the more debt ﬁnancing in relation to equity.

168 FINANCIAL MANAGEMENT
FINANCIAL DISTRESS
A company that has difﬁculty making payments to its creditors is in ﬁnancial
distress. Not all companies in ﬁnancial distress ultimately enter into the legal
status of bankruptcy. However, extreme ﬁnancial distress may very well lead
to bankruptcy.3
The Role of Limited Liability

Limited liability limits owners’ liability for obligations to the amount of
their original investment in the shares of stock. Limited liability for ownersof some forms of business creates a valuable right and an interesting incen-tive for shareholders. This valuable right is the right to default on obligations
to creditors—that is, the right not to pay creditors. Because the most share-

holders can lose is their investment, there is an incentive for the company totake on very risky projects: If the projects turn out well, the company pays
creditors only what it owes and keeps the remainder and if the projects turn
out poorly, it pays creditors what it owes—if there is anything left.
The fact that owners with limited liability can lose only their initial

investment—the amount they paid for their shares—creates an incentive forowners to take on riskier projects than if they had unlimited liability: They
have little to lose and much to gain. Owners of a company with limited
liability have an incentive to take on risky projects since they can onlylose their investment in the company. But they can beneﬁt substantially if
the payoff on the investment is high. You can see this by looking back at

Exhibit 8.2. The return on equity for Company LL is much more than thatof Company NL.
4
For companies whose owners have limited liability, the more the assets
are ﬁnanced with debt, the greater the incentive to take on risky projects,leaving creditors “holding the bag” if the projects turn out to be unproﬁtable.
This is a problem for it poses a conﬂict of interest between shareholders’

interests and creditors’ interests. The investment decisions are made by man-agement (who represent the shareholders) and, because of limited liability,
there is an incentive for management to select riskier projects that may harm
creditors who have entrusted their funds (by lending them) to the company.
3While bankruptcy is often a result of ﬁnancial difﬁculties arising from problems in
paying creditors, some bankruptcy ﬁlings are made prior to distress when a large

claim is made on assets (for example, class action liability suit).
4As long as the return on equity is above the break-even point, the return on the
levered company is greater than the return on the nonlevered company. Below that
break-even point is where the advantage of limited liability lies.

The Corporate Financing Decision 169
The right to default is a call option: The owners have the option to
buy back the entire company by paying off the creditors at the face value
of their debt. As with other types of options, the option is more valuable,the riskier the cash ﬂows. However, creditors are aware of this and demand

a higher return on debt (and hence a higher cost to the company). Jensen
and Meckling analyze the agency problems associated with limited liability.
5
They argue that creditors are aware of the incentives the company has to
take on riskier projects. Creditors will demand a higher return and may
also require protective provisions in the loan contract. The result is thatshareholders ultimately bear a higher cost of debt.
Costs of Financial Distress

The costs related to ﬁnancial distress without legal bankruptcy can take
different forms. For example, to meet creditors’ demands, a company takes
on projects expected to provide a quick payback. In doing so, the ﬁnancialmanager may choose a project that decreases owners’ wealth or may forgo
a proﬁtable project.
Another cost of ﬁnancial distress is the cost associated with lost sales.

If a company is having ﬁnancial difﬁculty, potential customers may shyaway from its products because they may perceive the company unable to
provide maintenance, replacement parts, and warranties. Lost sales due tocustomer concerns represent a cost of ﬁnancial distress—an opportunity
cost, something of value (sales) that the company would have had if it were
not in ﬁnancial difﬁculty.
Still another example of a cost of ﬁnancial distress is the cost associated

with suppliers. If there is concern over the company’s ability to meet itsobligations to creditors, suppliers may be unwilling to extend trade creditor may extend trade credit only at unfavorable terms. Also, suppliers may
be unwilling to enter into long-term contracts to supply goods or materials.
This increases the uncertainty that the company will be able to obtain these
items in the future and raises the costs of renegotiating contracts.

Bankruptcy and Bankruptcy Costs When a company is having difﬁculty
paying its debts, there is a possibility that creditors will foreclose (that is,
demand payment) on loans, causing the company to sell assets that could im-
pair or cease the company’s operations. But if some creditors force payment,
5Michael C. Jensen and William H. Meckling, “Theory of the Firm: Managerial
Behavior, Agency Costs, and Ownership Structure,” Journal of Financial Economics
3 (1976): 305–360.

170 FINANCIAL MANAGEMENT
this may disadvantage other creditors. So what has developed is an orderly
way of dealing with the process of the company paying its creditors—theprocess is called bankruptcy.
Bankruptcy in the United States is governed by the Bankruptcy Code,

which is found under U.S. Code Title 11. A company may be reorganizedunder Chapter 11 of this Code, resulting in a restructuring of its claims, or
liquidated under Chapter 7.
Chapter 11 bankruptcy provides the troubled company with protection
from its creditors while it tries to overcome its ﬁnancial difﬁculties. A com-pany that ﬁles bankruptcy under Chapter 11 continues operations during

the process of sorting out which of its creditors get paid and how much. Onthe other hand, a company that ﬁles under bankruptcy Chapter 7, under
the management of a trustee, terminates its operations, sells its assets, and
distributes the proceeds to creditors and owners.
We can classify bankruptcy costs into direct and indirect costs. Direct
costs include the legal, administrative, and accounting costs associated withthe ﬁling for bankruptcy and the administration of bankruptcy. The indirect

costs of bankruptcy are more difﬁcult to evaluate. Operating a company
while in bankruptcy is difﬁcult, since there are often delays in making de-cisions, creditors may not agree on the operations of the company, and
the objectives of creditors may be at variance with the objective of efﬁcient
operation of the company.
Another indirect cost of bankruptcy is the loss in value of certain assets.

If the company has assets that are intangible or for which there are valuablegrowth opportunities or options, it is less likely to borrow because the lossof value in the case of ﬁnancial distress is greater than, say, a company with
marketable assets. Because many intangible assets derive their value from the
continuing operations of the company, the disruption of operations duringbankruptcy may change the value of the company. The extent to which the

value of a business enterprise depends on intangibles varies among industries
and among companies; so the potential loss in value from ﬁnancial distress
varies as well. For example, a drug company may experience a greater
disruption in its business activities, than say, a steel manufacturer, sincemuch of the value of the drug company may be derived from the research
and development that leads to new products.
Financial Distress and Capital Structure The relationship between ﬁnan-

cial distress and capital structure is simple: As more debt ﬁnancing is used,
ﬁxed legal obligations increase (interest and principal payments), and theability of the company to satisfy these increasing ﬁxed payments decreases.
Therefore, as more debt ﬁnancing is used, the probability of ﬁnancial distress
and then bankruptcy increases.

The Corporate Financing Decision 171
For a given decrease in operating earnings, a company that uses debt to
a greater extent in its capital structure (that is, a company that uses more
ﬁnancial leverage), has a greater risk of not being able to satisfy the debt
obligations and increases the risk of earnings to owners.

Another factor to consider in assessing the probability of ﬁnancial dis-
tress is the business risk of the company. As discussed earlier, the businessrisk interacts with the ﬁnancial risk to affect the risk of the company.
Management’s concern in assessing the effect of ﬁnancial distress on the
value of the company is the present value of the expected costs of ﬁnan-cial distress. And the present value depends on the probability of ﬁnancial

distress: The greater the probability of ﬁnancial distress, the greater theexpected costs of ﬁnancial distress.
The present value of the costs of ﬁnancial distress increases with the
increasing relative use of debt ﬁnancing because the probability of ﬁnancial
distress increases with increases with ﬁnancial leverage. In other words, as
the debt ratio increases, the present value of the costs of ﬁnancial distressincreases, lessening some of the value gained from the use of tax deductibility

of interest expense.
Management does not know the precise manner in which the probability
of distress increases as the debt-to-equity ratio increases. Yet, it is reasonableto think that as the company increases its use of debt, relative to equity, in
ﬁnancing its operations and assets:
■The likelihood of distress increases.
■The beneﬁt from the tax deductibility of interest increases.
■The present value of the cost of ﬁnancial distress increases.
THE COST OF CAPITAL

The capital structure of a company is intertwined with the company’s cost
of capital. The cost of capital is the return that must be provided for the
use of an investor’s funds. If the funds are borrowed, the cost is related to
the interest that must be paid on the loan. If the funds are equity, the cost
is the return that investors expect, both from the stock’s price appreciation
and dividends. The cost of capital is a marginal concept. That is, the cost of

capital is the cost associated with raising one more dollar of capital.
There are two reasons for determining a corporation’s cost of capi-
tal. First, the cost of capital is often used as a starting point (a bench-mark) for determining the cost of capital for a speciﬁc project. Often
in capital budgeting decisions, the company’s cost of capital is adjusted
upward or downward depending on whether the project’s risk is more

172 FINANCIAL MANAGEMENT
than or less than the company’s typical project. Second, many of a com-
pany’s projects have risk similar to the risk of the company as a whole.So the cost of capital of the company is a reasonable approximation for
the cost of capital of one of its projects that are under consideration for
investment.

A company’s cost of capital is the cost of its long-term sources of funds:
debt, preferred stock, and common stock. And the cost of each source re-ﬂects the risk of the assets the company invests in. A company that investsin assets having little risk will be able to bear lower costs of capital than a
company that invests in assets having a high risk. Moreover, the cost of each

source of funds reﬂects the hierarchy of the risk associated with its seniorityover the other sources. For a given company, the cost of funds raised through
debt is less than the cost of funds from preferred stock which, in turn, is
less than the cost of funds from common stock. This is because creditors
have seniority over preferred shareholders, who have seniority over common

shareholders. If there are difﬁculties in meeting obligations, the creditorsreceive their promised interest and principal before the preferred share-
holders who, in turn, receive their promised dividends before the common
shareholders.
For a given company, debt is less risky than preferred stock, which is

less risky than common stock. Therefore, preferred shareholders require agreater return than the creditors and common shareholders require a greaterreturn than preferred shareholders. Figuring out the cost of capital requires
us to determine the cost of each source of capital the company expects to
use, along with the relative amounts of each source of capital the companyexpects to raise. Putting together all these pieces, the company can then

estimate the marginal cost of raising additional capital.
We estimate the company’s cost of capital in three steps:

The Corporate Financing Decision 173
We estimate the proportion of each source of capital using the com-
pany’s target capital structure. We do not use book values of capital from
the balance sheet because these are historical costs and may not represent
how the company intends to raise new capital.
In calculating the cost of each ﬁnancing source, we estimate the cost of

raising additional capital from each source; in other words, their marginalcosts. The cost of debt is the after-tax cost of debt, which we can estimate
by using current yields on the company’s debt, multiplied by one minusthe company’s marginal tax rate. If r
dis the marginal cost of debt before
adjusting for taxes and tis the marginal tax rate, then the after-tax cost of
debt, r∗
d,i s
r∗
d=rd×(1−t)
Why adjust for taxes? Because interest on debt is deductible for tax

purposes, so the cost of the debt is not the current yield, but rather the yieldadjusted for the tax deductibility of interest.
We can estimate the cost of preferred stock by using current yields on
the company’s preferred stock, if applicable. However, the cost of equity isby far much more difﬁcult to estimate. There are several models available
for estimating the cost of equity, including the dividend valuation model and

the capital asset pricing model. What is critical to understand is that thesedifferent models can generate signiﬁcantly different estimates for the cost of
common stock and, as a result, the estimated cost of capital will be highly
sensitive to the model selected.
In the case of both preferred stock and common stock, there is no
adjustment for taxes because the distributions to shareholders are paid outof after-tax dollars. In other words, dividends paid on stock are not taxdeductible.

The last step is to weight the cost of each source of funding by the pro-
portion of that source in the target capital structure. This weighted average
represents the marginal cost of raising an additional $1 of new capital. See
Exhibit 8.3.
As a company adjusts its capital structure, its cost of capital also changes.

Up to a point, using more debt relative to equity will lower the cost of capitalbecause the after-tax cost of debt is less than the cost of equity. Thereis some point, however, when the likelihood and, hence, cost of ﬁnancial
distress increases and may in fact outweigh the beneﬁt from taxes. After this
point—wherever this may be—the cost of both debt and equity increasesbecause both are much riskier.
Therefore, the trade-off theory of capital structure dictates that as the

company uses more debt relative to equity, the value of the company is

174 FINANCIAL MANAGEMENT
EXHIBIT 8.3 Example of the Cost of Capital Calculation
Consider a company with the following information:
Source of CapitalTarget
Capital
Structure
ProportionsPretax Costs
of Capital
Debt 40% 5%
Preferred stock 10% 6%
Common stock 50% 12%
What is this company’s cost of capital if the company’s marginal tax rate is 40%?
Solution

Solution
The after-tax cost of debt is 5% ×(1−0.40) =3%. Therefore, the weighted
average of the costs of capital is 7.8%:
Cost of capital =(40% ×3%)+(10% ×6%)+(50% ×12%) =7.8%
This means that for every $1 the company plans to obtain from ﬁnancing, the cost
is 7.8%.
enhanced from the beneﬁt of the interest tax shields. But the theory also
states that there is some point at which the likelihood of ﬁnancial distress
increases such that there is an ever-increasing likelihood of bankruptcy.6

Therefore:
■The value of the company declines as more and more debt is used,
relative to equity.
■The cost of capital increases because the costs of the different sources
of capital increase.
Though the trade-off theory simpliﬁes the world too much, it gives
the management an idea of the trade-offs involved. Introduce the value of
ﬁnancial ﬂexibility and the governance value of debt, and management hasthe key inputs to consider in the capital structure decision.

6This is why we noted earlier in the chapter that we assumed that the interest on
debt was the same for Company L and for Company LL, even though this was not
realistic. Because of the increased likelihood of distress, Company LL’s cost of debt
should be higher than that of Company L.

The Corporate Financing Decision 175
TRY IT! COST OF CAPITAL
Source of CapitalTarget Capital
Structure ProportionsPretax Costs
of Capital
Debt 25% 6.5%
Common stock 75% 10%
If the company’s marginal tax rate is 40%, what is the company’s
cost of capital?
OPTIMAL CAPITAL STRUCTURE:
THEORY AND PRACTICE

Management can try to evaluate whether there is a capital structure that
maximizes the value of the company. This capital structure, if it exists, is re-
ferred to as the optimal capital structure. However, even if the company’s op-
timal capital structure cannot be determined precisely, management should
understand that there is an economic beneﬁt from the tax deductibility of

taxes, but eventually this beneﬁt may be reduced by the costs of ﬁnancial
distress.
Looking at the ﬁnancing behavior of companies in conjunction
with their dividend and investment opportunities, we can make severalobservations:
■Companies prefer using internally generated capital (retained earnings)to externally raised funds (issuing equity or debt).
■Companies try to avoid sudden changes in dividends.

■When internally generated funds are greater than needed for investmentopportunities, companies pay off debt or invest in marketable securities.
■When internally generated funds are less than needed for investment op-
portunities, companies use existing cash balances or sell off marketable
■If companies need to raise capital externally, they issue the safest security
ﬁrst; for example, debt is issued before preferred stock, which is issued
before common equity.

176 FINANCIAL MANAGEMENT
The trade-off among taxes and the costs of ﬁnancial distress leads to
the belief that there is some optimal capital structure, such that the value
of the company is maximized. Yet it is difﬁcult to reconcile this with some
observations in practice. Why?
One possible explanation is that the trade-off analysis is incomplete.

We didn’t consider the relative costs of raising funds from debt and equity.Because there are no out-of-pocket costs to raising internally generated funds
(retained earnings), it may be preferred to debt and to externally raisedfunds. Because the cost of issuing debt is less than the cost of raising a similar
amount from issuing common stock (typically ﬂotation costs of 2.2% versus
7.1%), debt may be preferred to issuing stock.
Another explanation for the differences between what we observe and

what we believe should exist is that companies may wish to build up ﬁnancialslack, in the form of cash, marketable securities, or unused debt capacity, to
avoid the high cost of issuing new equity.
Still another explanation is that management may be concerned about
the signal given to investors when equity is issued. It has been observed that
the announcement of a new common stock issue is viewed as a negative

signal, since the announcement is accompanied by a drop in the value ofthe equity of the company. It is also observed that the announcement of
the issuance of debt does not affect the market value of equity. Therefore,
management must consider the effect that the new security announcementmay have on the value of equity and therefore may shy away from issuing
new equity.
The concern over the relative costs of debt and equity and the concern

over the interpretation by investors of the announcement of equity ﬁnancingleads to a preferred ordering, or pecking order ,of sources of capital: ﬁrst
internal equity, then debt, then preferred stock, then external equity (new
common stock). A result of this preferred ordering is that companies prefer
to build up funds, in the form of cash and marketable securities, so as not
to be forced to issue equity at times when internal equity (that is, retained

earnings) is inadequate to meet new proﬁtable investment opportunities.
7
Modigliani-Miller Theory of Capital Structure
Franco Modigliani and Merton Miller provide a theory of capital structurethat is a framework for the discussion of the factors most important in a com-
pany’s capital structure decision: taxes, ﬁnancial distress, and risk. Though
7For a more complete discussion of the pecking order explanation, especially the role

of asymmetric information, see Stewart C. Myers, “The Capital Structure Puzzle,”
Midland Corporate Finance Journal 3 (1985): 65–76.

The Corporate Financing Decision 177
this theory does not give a prescription for capital structure decisions, it does
offer a method of examining the role of these important factors that pro-vide the ﬁnancial manager with the basic decision-making tools in analyzing
the capital structure decision. Within their theory, Modigliani and Miller

demonstrate that without taxes and costs of ﬁnancial distress, the capitalstructure decision is irrelevant to the value of the company.
The capital structure decision becomes value-relevant when taxes are
introduced into the situation, such that an interest tax shield from the taxdeductibility of interest on debt obligations encourages the use of debt be-
cause this shield becomes a source of value. Financial distress becomes rel-

evant because costs associated distress mitigate the beneﬁts of debt in thecapital structure, offsetting or partially offsetting the beneﬁt from interest
deductibility. The value of a company—meaning the value of all its assets—is
equal to the sum of its liabilities and its equity (the ownership interest). Does
the way we ﬁnance the company’s assets affect the value of the company
and hence the value of its owners’ equity? Yes. How does it affect the valueof the company?

M&M Irrelevance Proposition Franco Modigliani and Merton Miller de-
veloped the basic framework for the analysis of capital structure and how
taxes affect the value of the company.
8The essence of this framework is that
what matters in the value of the company is the company’s operating cashﬂows and the uncertainty associated with these cash ﬂows.
Modigliani and Miller (M&M) reasoned that if the following conditions
hold, the value of the company is not affected by its capital structure:

Condition 1: Individuals and corporations can borrow and lend at the
same terms (referred to as equal access).
Condition 2: There is no tax advantage associated with debt ﬁnancing
vis-`a-vis to equity ﬁnancing.
Condition 3: Debt and equity trade in a market where assets that are
substitutes for one another, they trade at the same price.
Under the ﬁrst condition, individuals can borrow and lend on the same
terms as the business entities. Therefore, if individuals are seeking a given

level of risk they can either: (1) borrow or lend on their own, or (2) invest
in a business that borrows or lends. In other words, if an individual investor
8Franco Modigliani and Merton H. Miller, “The Cost of Capital, Corporation Fi-
nance, and the Theory of Investment,” American Economic Review 48 (1958):
261–297.

178 FINANCIAL MANAGEMENT
wants to increase the risk of the investment, the investor could choose to
invest in a company that uses debt to ﬁnance its assets. Or the individualcould invest in a company with no ﬁnancial leverage and take out a personal
loan—increasing the investor’s own ﬁnancial leverage.
The second condition isolates the effect of ﬁnancial leverage. If deducting

interest from earnings is allowed in the analysis, it would be difﬁcult to ﬁgureout what effect ﬁnancial leverage itself has on the value of the company.
M&M relax this later, but at this point assume no tax advantage existsbetween debt or equity securities—either for the company or the investor.
The third condition ensures that assets are priced according to their risk

and return characteristics. This condition establishes what is referred to as aperfect capital market: If assets are traded in a perfect market, the value of
assets with the same risk and return characteristics trade for the same price.
Under these conditions, the value of a company is the same, no matter
how it chooses to ﬁnance itself. The total cash ﬂow to owners and creditors is
the same and the value of the company is the present value of the company’s
operating cash ﬂows in perpetuity.

M&M show that in the simpliﬁed world without taxes or costs of
distress, the value of the company depends on the cash ﬂows of the company,not on how the company’s cash ﬂows are divided between creditors and
owners. An implication of the M&M analysis is that the use of debt ﬁnancing
increases the risk of the future cash ﬂows to owners and, therefore, increasesthe discount rate investors use to value these future earnings. M&M reason

that the effect that the increased expected cash ﬂows has on the value of
equity is just offset by the increased discount rate applied to these riskierearnings, keeping the cost of capital the same no matter the capital structure.
M&M with Tax Deductibility of Interest Paid on Debt M&M’s second
proposition is that when interest on debt is deducted in determining taxable
income, but dividends are not, the value of the company is enhanced because

of this tax deductibility of interest. When Modigliani and Miller introduce
the tax deductibility of interest into the framework, the use of debt has a
distinct advantage over ﬁnancing with stock. The deductibility of interestrepresents a form of a government subsidy of ﬁnancing activities; the gov-
ernment is sharing the company’s cost of debt. We refer to the beneﬁt from
interest deductibility as the interest tax shield because the interest expense

shields income from taxation. The tax shield from interest deductibility is
the amount by which taxes are reduced by the deduction for interest.
If there are no costs associated with ﬁnancial distress, then the value of
the company increases with ever-increasing use of debt ﬁnancing becauseof the value enhancement from the use of the interest tax shield. Further, if
there are no costs to ﬁnancial distress, the cost of capital for the company

The Corporate Financing Decision 179
decreases with ever-increasing use of debt ﬁnancing because the after-tax
cost of debt affects the cost of capital for the company as a whole such thatthe increased use of the debt reduces the cost of capital.
Is there a limit to how much debt a company can take on? As long as

there are no costs to ﬁnancial distress, the only limit is the existence of atleast a small percentage of equity in the capital structure.
9
Capital Structure Theory and Costs to Financial Distress If the debt bur-
den is too much, the company may experience ﬁnancial distress, resulting
in an increasing cost of capital: At some point, the value of the company

declines and the cost of capital increases with increasing use of debt ﬁ-nancing. Financial distress results in both direct and indirect costs including
legal costs, opportunity costs for projects, and the effect of distress on the
relationship with customers and suppliers.
At some capital structure, these costs begin to offset the beneﬁt of the

interest deductibility of debt. The optimal capital structure is the point atwhich the value of the company is maximized. Up until the optimal capitalstructure, the beneﬁts from the tax deductibility of interest outweigh the
cost of ﬁnancial distress. When the amount of ﬁnancial leverage exceeds the
optimal capital structure, the beneﬁts from the tax deductibility of interest
are outweighed by the cost of ﬁnancial distress. Because of the relation be-

tween the value of the company and the cost of capital, the capital structurethat maximizes the value of the company is the same capital structure that
minimizes the cost of capital.
The problem is that we cannot determine beforehand what the optimal
capital structure is for a given company. The theory is not prescriptive interms of identifying this precise point. What we can observe is when a

company takes on too much debt and distress occurs. The optimal capitalstructure depends, in large part, on the business risk of the company: the
greater the business risk of the company, the sooner this optimal capital
structure is reached.
So what good is the theory of capital structure if ﬁnancial managers
cannot determine the optimal capital structure? The M&M theory, alongwith subsequent, related theories and evidence, provides a framework fordecision making:

■There is a beneﬁt to taking on debt—to a point.
■The cost of capital of a company decreases with ever-increasing use of
debt ﬁnancing—to a point.
9In theory and in practicality, there always must be some equity in a company, even
if it is very little.

180 FINANCIAL MANAGEMENT
■The optimal capital structure depends on the risk associated with the
company’s operating cash ﬂows.
Current Capital Structure Theory and Practice The M&M theory of-
fers a trade-off model of capital structure: some balance exists between thepresent value of the interest tax shields and the present value of the costs of

ﬁnancial distress. We simply cannot determine, based on this theory, where
this point is for a given company.
Since M&M introduced their theory of capital structure in a series of
articles, there have been many other considerations offered by researchers,including:
■Agency costs that may complicate the maximization of shareholders’wealth.
10
■Asymmetric information and signaling that result in a pecking order ofﬁnancing choices.
11

11
■Nonﬁnancial stakeholder issues that may affect the costs of ﬁnancial
distress.12
These additional considerations complicate the analysis, but do not
replace the fundamental concept that there is a trade-off between the beneﬁts
of debt and the costs of having too much debt.
■A company may ﬁnance its business operations by raising funds inter-nally, through retained earnings, issuing stock, or borrowing.
■Using borrowed funds, as compared to using equity, as a source of

ﬁnancing increases the risk to owners at the same time potentially en-
hancing the returns to owners through a leveraging effect.
■A way to view the choice of ﬁnancing is to calculate the degree of
ﬁnancial leverage, which is the ratio of operating earnings to earnings
after deducting interest.
10Jensen and Meckling, “Theory of the Firm: Managerial Behavior, Agency Costs,
and Ownership Structure.”
11Myers, “The Capital Structure Puzzle”; and Stewart C. Myers and N. S. Majluf,

“Corporate Financing and Investment Decisions when Firms Have Information
Investors Do Not Have,” Journal of Financial Economics 13 (1984): 187–221.
12Mark Grinblatt and Sheridan Titman, Financial Markets and Corporate Strategy
(Boston: Irwin/McGraw-Hill, 2002).

The Corporate Financing Decision 181
■Failure to pay interest or principal as promised may result in ﬁnancial
distress, the condition where a company makes decisions under pres-sure to satisfy its legal obligations to its creditors. These decisions may
not be in the best interests of the owners of the company. The costs

related to ﬁnancial distress without legal bankruptcy can take differentforms.
■The use of debt also reduces a company’s ﬁnancial ﬂexibility. The man-agement of a company that has ﬁnancial slack (i.e., debt capacity that isunused) is more prepared to take advantage of investment opportunities
in the future.
■The use of debt may enhance the value of equity because owners do
not have to share income with creditors beyond the required interest

payment on the debt, while owners beneﬁt from the tax subsidy pro-
vided to companies that use debt ﬁnancing. There may be a point,
however, when amount of ﬁnancing from debt becomes too much, and
the company becomes distressed and may end up in bankruptcy.
■Though theory identiﬁes the beneﬁts of debt and the potential ﬁnancial
distress when a company takes on too much debt, we cannot tell at
what point a company has taken on too much debt—until it becomesdistressed.

■The cost of capital of a company is affected by the mix of debt andequity ﬁnancing: the cost of capital is reduced as the company takeson more debt, but only to a point—after which it rises as the company
encounters costs of ﬁnancial distress that outweigh the tax advantages
of debt.
■Management can try to evaluate whether there is an optimal capital
structure (i.e., a capital structure that maximizes the value of the com-

pany). However, even if the company’s optimal capital structure cannotbe determined precisely, management should understand that there is
an economic beneﬁt from the tax deductibility of taxes, but eventually
this beneﬁt may be reduced by the costs of ﬁnancial distress.
■The Modigliani Miller theory of capital structure provides a frameworkfor the discussion of the factors most important in a company’s capitalstructure decision: taxes, ﬁnancial distress, and risk. Though this theory

does not give a prescription for capital structure decisions, it does offer
a method of examining the role of these important factors that aid man-agement with the basic decision-making tools in analyzing the capital
structure decision.
■According to the Modigliani-Miller theory of capital structure, in the
absence of taxes and costs of ﬁnancial distress, the capital structure
decision is irrelevant to the value of the company. The capital structure

decision becomes relevant when taxes are introduced into the analysis,

182 FINANCIAL MANAGEMENT
such that an interest tax shield from the tax deductibility of interest on
debt obligations encourages the use of debt because this shield becomesa source of value.
Returns with Leverage
In MillionsOperating earnings $5.00
$2.50
Net income $2.50
Return on assets 2.5%
Return on equity 5.0%

Returns with Leverage and Taxes
Interest on debt $2.50
Taxable income $2.50
Taxes at 40% $1.00
Net income $1.50
Return on assets 1.5%
Return on equity 3.0%
Cost of Capital
Capital
Structure
ProportionsPretax
Costs of
CapitalCosts
of
Capital Weight ×Cost
Debt 25% 6.5% 3.9% 0.975%
Common stock 75% 10% 10% 7.500%
100% Cost of capital = 8.475%

The Corporate Financing Decision 183
QUESTIONS
1.Brieﬂy explain the role of ﬁnancial leverage in affecting returns on
equity.
2.What is an interest tax shield, and how does this affect the value of acompany?
3.If a company’s marginal tax rate were to increase, what is the effect on
the interest tax shield from the company’s debt?

4.If a company has a degree of ﬁnancial leverage of 2.0, what is the
expected effect of a 2% increase in operating earnings to the earnings
to owners?
5.How may using debt ﬁnancing increase the governance of a company?
6.Explain how limited liability may affect the capital structure decisionsof a corporation.
7.If there are costs associated with ﬁnancial distress, how may this affectthe capital structure decision of a company?

8.Why do we adjust for taxes in determining the cost of debt, but not for
the costs of preferred stock and common stock?
9.What is traded off in the trade-off theory of capital structure?
10.What is the relation between a company’s operating risk and its optimalcapital structure?
11.What is meant by the pecking order theory of capital structure?
12.What are the implications of the Modigliani-Miller theory of capitalstructure when the assumption of no corporate taxes is not valid?

13.Consider three ﬁnancing alternatives:Alternative A: Finance solely with equityAlternative B: Finance using 50% debt, 50% equity
Alternative C: Finance solely with debt
a.Which of the three alternatives involves the greatest ﬁnancial
leverage?
b.Which of the three alternatives involves the least ﬁnancial leverage?
14.List the potential costs associated with ﬁnancial distress.
15.List the potential direct and indirect costs associated with bankruptcy.
16.Regarding ﬁnancial slack:
a.What is it?

b.How is slack created?
c.Why do companies wish to have ﬁnancial slack?

184

c09 JWBT310-Fabozzi July 1, 2010 12:54 Printer: Courier Westford, Westford, MA
CHAPTER9
Financial Risk Management
But innovation is more than a new method. It is a new view of the
universe, as one of risk rather than of chance or of certainty. It is a
new view of man’s role in the universe; he creates order by taking
risks. And this means that innovation, rather than beingan assertion of human power, is an acceptance of human
responsibility.

—Peter F. Drucker, Landmarks of Tomorrow
(New York: Harper Colophon Books, 1959)
All companies face a variety of risks. Scandals such as Enron, WorldCom,Tyco, and Adelphia, the tragic events such as 9/11, and the economic
downturn associated with the U.S. subprime mortgage crisis have reinforced
the need of companies to manage risk. Moreover, risk management should
not be an after-thought, but instead should be a key element of any invest-
ment or ﬁnancing decision.

In this chapter we discuss the four key processes in ﬁnancial risk man-
agement: risk identiﬁcation, risk assessment, risk mitigation, and risk trans-ferring. The process of risk management involves determining which risksto accept, which to neutralize, and which to transfer.
THE DEFINITION OF RISK
There is no shortage of deﬁnitions for risk. We often refer to riskas the

uncertainty regarding what may happen in the future. In some deﬁnitions,risk is distinguished from uncertainty, such that risk is uncertainty that canbe quantiﬁed.
In everyday parlance, risk is often viewed as something that is negative,
such as a danger, a hazard, or a loss. But we know that some risks lead
185

186 INVESTMENTS
to economic gains, while others have purely negative consequences. For
example, the purchase of a lottery ticket involves an action that results inthe risk of the loss equal to the cost of the ticket, but potentially has a
substantial monetary reward. In contrast, the risk of death or injury from a
random shooting is purely a negative consequence.

In the corporate world, accepting risks is necessary to obtain a competi-
tive advantage and generate a proﬁt. Introducing a new product or expand-ing production facilities involves both return and risk. When a company isexposed to an event that can cause a shortfall in a targeted ﬁnancial mea-
sure or value, this is ﬁnancial risk . The ﬁnancial measure or value could
be earnings per share, return on equity, or cash ﬂows, to name some of

the important ones. Financial risks include market risk, credit risk, market
liquidity risk, operational risk, and legal risk.
The word “risk” is derived from the Italian verb riscare , which
means “to dare.” Business entities therefore “dare to” generateproﬁts by taking advantage of the opportunistic side of risk.
We can classify risks as core risks andnoncore risks. The distinction is

important in the management of risk. In attempting to generate a return oninvested funds that exceeds the risk-free interest rate, a company must bear
risk. The core risks are those risks that the company is in the business tobear and the term business risk is used to describe this risk.
In contrast to core risk, risks that are incidental to the operations of a
business are noncore risks. To understand the difference, consider the risk

associated with the uncertainty about the price of electricity. For a com-
pany that produces and sells electricity, the risk that the price of electricity
that it supplies may decline is a core risk. However, for a manufacturing
company that uses electricity to operate its plants, the price risk associated
with electricity (i.e., the price increasing) is a noncore risk. Yet changing thecircumstances could result in a different classiﬁcation. For example, suppose

that the company producing and selling electricity is doing so on a ﬁxed-
price contract for the next three years. In this case, the price risk associatedwith electricity is a non core risk.
Sustainability Risk
In the past, the management of risks that a company faces has focused on its
business and ﬁnancial risks. The business risks include the sales risk —driven

Financial Risk Management 187
by competition and demand—and operating risks , affected by the struc-
ture of operating costs. The ﬁnancial risks relate to the use of debt in the
company’s capital structure.
Take calculated risk. That is quite different from being rash.
—George Patton
In the past two decades there has been a broadening of the perception of

risk to extend traditional business and ﬁnancial risks to the complete spec-trum of risk that a company faces that includes social and environmental
responsibilities. This broad spectrum of risk is sustainability risk . For exam-
ple, the social responsibilities of a company include labor and human rights,working conditions, training, governance, and ethics, whereas the environ-

mental responsibilities include recycling and waste management, oversight,reporting, and resource use. Without effective management of these risks,
a business risks the potential damages from boycotts, shareholder actions,
lawsuits, and additional regulations.
The concept of sustainability has slowly gained prominence in the past

two decades as investors, regulators, and companies grappled with the effectsof corporate scandals, catastrophes, and tragedies. Many began to questionwhether the objective of the company as shareholder wealth maximization is
too simplistic. In other words, the question arises as to whether a company is
valued considering not only its ﬁnancial performance, but its environmentaland social responsibility records as well. There is no deﬁnitive empirical

evidence that the environmental and social dimensions of a company affect
its value, but there is anecdotal evidence that investors may consider thesedimensions.
As the issue of sustainability has grown in prominence, there has
also been a surge of measures of companies’ sustainability risk, including
the Institutional Shareholders Services Sustainability Risk Reports and the

Deloitte Sustainability Reporting Scorecard. In addition, indexes, includingthe Dow Jones Sustainability Indexes (DJSI) and the FTSE4Good indexes,
have been created that track the performance of companies focusing on sus-
tainability. Further, many companies are now reporting their sustainabilityrisk and risk management efforts to investors. For example, some com-
panies now report on sustainability using the framework provided by the

Global Reporting Initiative (GRI), though others develop their own report-ing frameworks. Though GRI and other measures are still evolving, there is
increasing pressure for some form of reporting on these risks.

188 INVESTMENTS
A lot of people approach risk as if it’s the enemy when it’s really
fortune’s accomplice.
—Sting, in a quote from an essay Sting wrote entitled
“Risk: Let Your Soul Be Your Bookie” that appears in
Sarah Ban Breathnach and Michael Segell,
A Man’s Journey to Simple Abundance
(New York: Scribner, 2000)
ENTERPRISE RISK MANAGEMENT

The traditional process of risk management focuses on managing the risksof only parts of the business (products, departments, or divisions), ignoring
the implications for the value of the company. The organization of a risk
management process focusing on only parts of a business is referred to as a
silo structure. What is needed is a process that management can employ to

effectively handle uncertainty and evaluate how the risks and opportunitiesthat a company faces can either create, destroy, or preserve a company’s
value. This process should allow management to:
■Align the risk appetite and strategies across the company.
■Improve the quality of the company’s risk-response decisions.
■Identify the risks across the company.
■Manage the risks across the company.
This process is enterprise risk management (ERM).

A company’s internal controls provide a mechanism for mitigating risks,
and increase the likelihood that a company will achieve its ﬁnancial objec-tive. As we will explain, ERM goes beyond internal controls in three sig-
niﬁcant ways. First, when establishing its strategy for the company, ERMrequires that the board consider risks. Second, ERM requires that the board
identify what level of risk it is willing to accept. Finally, ERM requires that

risk management decisions be made throughout the company in a mannerconsistent with the risk policy established.
Definitions of ERM
Enterprise risk management is an ongoing process that provides a structuredmeans for reducing the adverse consequences of big surprises due to natural
catastrophes, terrorism, changes in the economic, political, and legal en-
vironments, tax litigation, failure of the company’s corporate governance,

Financial Risk Management 189
and product and ﬁnancial market volatility. In fact, Moody’s states that the
ultimate objective of a company’s risk management organization should beto make sure that there are no major surprises that place the company in
peril.
1Second, the starting point for an effective ERM system is at the board

level. This means that corporate governance is a critical element.
DEFINITIONS OF ENTERPRISE RISK MANAGEMENT
The most popular deﬁnition is proposed by the Committee of Spon-
soring Organizations of the Treadway Commission (COSO):
“a process, effected by an entity’s board of directors, man-
agement and other personnel, applied in strategy setting and
across the enterprise, designed to identify potential events thatmay affect the entity, and manage risk to be within its risk ap-

petite, to provide reasonable assurance regarding the achieve-
ment of entity objectives.”
*
The Casualty Actuarial Society (CAS) provides a broader deﬁnition
of ERM:
“the discipline by which an organization in any industry as-sesses, controls, exploits, ﬁnances, and monitors risk from allsources for the purposes of increasing the organization’s short-
and long-term value to its stakeholders.”
**
*Committee of Sponsoring Organizations of the Treadway Commission,

Enterprise Risk Management—Integrated Framework Executive Summary
(September 2004), p. 8.
**Casualty Actuarial Society, Overview of Enterprise Risk Management (May
2003).
The term “enterprise” can have different meanings within ERM.2One is
that ERM is linked to strategic planning and organizational objectives of the
1Moody’s, “Risk Management Assessments,” Moody’s Research Methodology (July
2004).
2As the Society of Actuaries (SOA) points out, there are two main deﬁnitions [Society

of Actuaries, Enterprise Risk Management Specialty Guide (May 2006), p. 9].

190 INVESTMENTS
business enterprise. The second deﬁnition is in terms of modern portfolio
theory (MPT) that we describe in Chapter 16. In this theory, formulated
by Harry Markowitz, the focus is on the risk of the portfolio and not the
individual securities comprising the portfolio.3In other words, the enterprise

is a portfolio in this context. This leads to the conclusion that it is notthe stand-alone risk of an individual security that is relevant but only thecontribution of that as asset makes to a portfolio’s risk.
A portfolio manager can use the basic ideas from MPT to create efﬁcient
portfolios, assembling a portfolio that offers the maximum expected returnfor a given level of risk. The portfolio manager’s task is to select one of

these efﬁcient portfolios given the manager’s or client’s risk appetite. The
manager can use derivatives instruments that we describe in Chapter 14 toalter the risk proﬁle of a portfolio and can use risk budgeting to decide
how to allocate risk. In the context of ERM, the enterprise is viewed as a
“portfolio of risks.” It is not stand-alone risk that is key, but the risk to theentire company. The risk proﬁle can be altered using derivative instruments

as well as other risk transfer products and strategies discussed later in this
chapter.
ERM Process
There is no ﬁxed formula for developing an ERM system, but rather somegeneral principles that provide guidance. This is because there is consider-able variation in company size, organizational structures (centralized versus
decentralized, for example), and types of risk faced in different industries.

So, although different internal controls vary from company to company, theunderlying principles do not. In the literature, there are several proposals
for the ERM process.
The four risk objectives of ERM are the following:
4
1.Strategic. Supporting the corporation’s strategic goals (i.e., high-level
goals).
2.Operations. Achieving performance goals and taking measures to safe-
guard against loss through operational efﬁciency.

3.Reporting. Providing reliable ﬁnancial and operational data and reports
internally and externally.
4.Compliance. Complying with laws and regulations at all levels (local,
state, national, and in other countries where the company operates).
3Harry M. Markowitz, “Portfolio Selection,” Journal of Finance 7(1952): 77–91.
4These are from the Committee of Sponsoring Organizations (COSO) framework.

Financial Risk Management 191
While there are common risks shared by all companies and there are
risks unique to some companies, the building blocks for the ERM process
are common to all companies.
Basically, ERM is chieﬂy concerned with
■evaluating the company’s risk processes and risk controls, and
■identifying and quantifying risk exposures.

ERM is broader in its scope than traditional risk management, which
focuses on products, departments, or divisions practiced within a silo struc-
ture. In ERM, all the risks of a company are treated as a portfolio of risksand managed on a portfolio or company level. That is, the risk context is
the company, not individual products, departments, or divisions.
For example, suppose that a company has a target minimum earnings

ﬁgure established either by its own ﬁnancial plan or based on Wall Streetanalysts’ consensus earnings. ERM can be used to identify the threats to the
company of hitting that target. Once those risks are identiﬁed and priori-tized, management can examine the potential shortfall that may occur and
decide how to reduce the likelihood that there will be a shortfall using some
risk transfer strategies.
Themes of ERM
There are four themes in enterprise risk management, as we detail inExhibit 9.1.
5

5
Therisk control process involves identifying, evaluating, monitoring,
and managing risk. The process of reﬂecting risk and risk capital in strategicoptions from which a corporation can select is called strategic risk manage-
ment . This process requires adjusting for risk in valuing investments, making
investment decisions, and evaluating an investment’s performance.
Catastrophic events are extreme events that could threaten the survival

of a company. Catastrophic risk management involves planning so as to
minimize the impact of potential catastrophic events and having in place an
early warning system that, if possible, could identify a potential disaster.
In catastrophic control, several analyses provide information. For ex-
ample, trend analysis can identify any patterns suggesting potential emer-gence of catastrophes, and stress testing can show the impact of a catas-

trophe on the ﬁnancial condition and reputation of the company. Once wehave an understanding regarding the possible scenarios, we can plan for
5The four themes are proposed by the Enterprise Risk Management Specialty Guide,
pp. 26–38.

192 INVESTMENTS
Risk controlStrategic risk
managementRisk management
cultureCatastrophic
control
 Identify risks

EXHIBIT 9.1 The Four Themes of Enterprise Risk Management
contingencies, prepare communication strategies for stakeholders, and con-sider effectiveness and cost to transfer risk.
The Society of Actuaries (SOA) deﬁnes a risk management culture as an
environment in which the entity has an approach to dealing with risks, andthat this approach is part of the entity’s culture. Hence, when a risk event
occurs, a plan is in place for dealing with this risk.
6

6
Reports that say something hasn’t happened are always interest-
ing to me because, as we know, there are known knowns; thereare things we know we know. We also know there are known un-
knowns; that is to say, we know there are some things we do not
know. But there are also unknown unknowns—the ones we don’t
know we don’t know.
—Donald Rumsfeld, U.S. Secretary of Defense
(Press Conference, Brussels, Belgium, June 6, 2002)
This culture requires that the entity identify and measure risks, and

examine best practices in the management of risk. In addition, the risk man-
agement culture requires that the entity develop a system of documentingrisk and risk management and communicating risk management policies and
practices to stakeholders. Further, a risk management culture should edu-
cate all employees or other decision-makers in risk management and providetraining regarding risk management. This education and training reinforces
the importance of risk management.

6Exhibit 9.1 is a summary of the description of the themes of risk management
provided by Enterprise Risk Management Specialty Guide, p. 26–28.

Financial Risk Management 193
Specifying an Entity’s Risk Policy
The implementation of an ERM policy requires that the amount of risk
that a company is willing to accept be speciﬁed. Corporations through their
board set the boundaries as to how much risk the company is prepared to
accept. Often in referring to risk, the terms risk appetite andrisk tolerance

are used interchangeably. However, there is a subtle distinction between the
two concepts.
Basically, the company’s risk appetite is the amount of risk exposure that
the entity decides it is willing to accept or retain.7When the risk exposure of
the entity exceeds the risk tolerance threshold, risk management processes
kick into return the exposure level back within the accepted range.
Once an entity has implemented a risk policy of the company, it is

important to communicate it to stakeholders. For a corporation, this isthrough the management discussion and analysis section required in SEC
ﬁlings (8-K and 10-K), press releases, communications with rating agencies,
and investor meetings. Now that the credit rating services are incorporatingERM measures into the credit rating process, it is more important than
ever for companies to pay attention to the company’s ERM system and to
communicate this system to stakeholders.
MANAGING RISKS

A company’s risk retention decision is how it elects to manage an identiﬁed
risk. This decision is more than a risk management decision, it is also aﬁnancing decision. The choices are:
■Retain
■Neutralize
■Transfer
Of course, each identiﬁed risk faced by the company can be treated in a
different way. For each of the three choices—retention, neutralization, and
transfer of risk—there are in turn two further decisions as to how they canbe handled.
Retained Risk and Risk Finance

The decision by a company of which identiﬁed risks to retain is based on aneconomic analysis of the expected beneﬁts versus expected costs associatedwith bearing that particular risk. The aggregate of all the risks across the
7Enterprise Risk Management—Integrated Framework Executive Summary ,p .2 .

194 INVESTMENTS
company that it has elected to bear is called its retained risk. Because if a
retained risk is realized it will adversely impact the company’s earnings and
cash ﬂows, a company must decide to fund or not fund a retained risk.
Anunfunded retained risk is a retained risk for which potential losses
are not ﬁnanced until they occur. In contrast, a funded retained risk is a

retained risk for which an appropriate amount is set aside up front (eitheras cash or an identiﬁed source for raising funds) to absorb the potential
loss. For example, with respect to corporate taxes, management may decide
to hold as cash reserves all or a portion of the potential adverse outcome oflitigation with tax authorities. This management of retained risk is referred
to as risk ﬁnance .
Risk Neutralization
If a company elects not to retain an identiﬁed risk, it can either neutralize

the risk or transfer the risk. Risk neutralization is a risk management policy
whereby a company acts on its own to mitigate the outcome of an expectedloss from an identiﬁed risk without transferring that risk to a third party.
This can involve reducing the likelihood of the identiﬁed risk occurring or
reducing the severity of the loss should the identiﬁed risk be realized. Riskneutralization management for some risks may be a natural outcome of the

business or ﬁnancial factors affecting the company.
Consider an example involving a business risk. Suppose that a company
projects an annual loss of $30 million to $50 million from returns due toproduct defects, and this amount is material relative to its proﬁtability. A
company can introduce improved production processes to reduce the upperrange of the potential loss.
As an example involving a ﬁnancial factor, a U.S. multinational com-

pany will typically have cash inﬂows and outﬂows in the same currency suchas the euro. As a result, there is currency risk—the risk that the exchange
rate moves adversely to the company’s exposure in that currency. But this
risk has offsetting tendencies if there are both cash inﬂows and outﬂows inthe same currency. Assuming the currency is the euro, the cash inﬂows are
exposed to a depreciation of the euro relative to the U.S. dollar; the cash

outﬂows are exposed to an appreciation of the euro relative to the U.S. dol-
lar. If the company projects future cash inﬂows over a certain time period
of€50 million and a cash outﬂow over the same period of €40 million,
the company’s net currency exposure is a €10 million cash inﬂow. That is,
€40 million exposure is hedged naturally.
Risk Transfer

For certain identiﬁable risks, the company may decide to transfer the riskfrom shareholders to a third party. This can be done either by entering into

Financial Risk Management 195
a contract with a counterparty willing to take on the risk the company seeks
to transfer, or by embedding that risk in a structured ﬁnancial transaction,thereby transferring it to bond investors willing to accept that risk.
There are various forms of risk transfer management . The vehicles or

instruments for transferring risk include traditional insurance, derivatives,alternative risk transfer, and structured ﬁnance.
Traditional Insurance The oldest form of risk transfer vehicle is insurance.
An insurance policy is a contract whereby an insurance company agrees to
make a payment to the insured if a deﬁned adverse event is triggered. The
insured receives the protection by paying a speciﬁed amount periodically,
called the insurance premium.

The contract can be a valued contract or unvalued contract. In a
valued contract , the policy speciﬁes the agreed value of the property in-
sured. With the exception of life insurance contracts purchased by compa-
nies, valued contracts are not commonly used as a form of risk transfer.
There are exceptions, of course, such as an art museum insuring valuableworks of art with the amount ﬁxed at the time of negotiation of the con-

tract to avoid needing an appraisal of the artwork after the insured event
is triggered.
In an unvalued contract , also called a contract of indemnity, the value of
the insured property is not ﬁxed. Rather, there may be a maximum amountpayable, yet the payment is contingent on the actual amount of the insured’sloss resulting from the trigger event. A contract of indemnity is the typical
type of contract used in risk transfer.

Derivatives As will be explained in Chapter 14, there are capital market
products available to transfer risks that are not readily insurable by an
insurance company. Such risks include risks associated with a rise in the
price of a commodity purchased as an input, a decline in a commodity
price of a product the company sells, a rise in the cost of borrowing funds,
and an adverse exchange-rate movement. Derivate instruments, which are

capital market instruments, can be used to provide such protection. These
instruments include futures contracts, forward contracts, option contracts,
swap agreements, and cap and ﬂoor agreements.
There have been shareholder concerns about the use of derivative instru-
ments by companies. This concern arises from major losses resulting frompositions in derivative instruments. However, an investigation of the reasonfor major losses would show that the losses were not due to derivatives per

se, but the improper use of them by management that either was ignorant
about the risks associated with using derivative instruments or sought to usethem in a speculative manner rather than as a means for managing risk.

196 INVESTMENTS
MISHAPS IN RISK MANAGEMENT
THROUGH DERIVATIVES
■Procter & Gamble lost $195.5 million in an interest rate swap in
1994, but its obligation to pay this to Bankers Trust was forgiven
in a settlement.
■Amaranth Advisors, a hedge fund, lost $6.4 billion in 2006 in
futures contracts on natural gas.
■Over several years, American International Group sold credit de-

fault swaps. When the credit quality of many bonds deteriorated
as the economy entered into a recession, AIG’s selling of swaps
resulted in its losing more than $18 billion in 2008.
Alternative Risk Transfer
Alternative risk transfer (ART), also known as structured insurance,p r o -
vides unique ways to transfer the increasingly complex risks faced by cor-porations that cannot be handled by traditional insurance and has led to

the growth in the use of this form of risk transfer. These products combine
elements of traditional insurance and capital market instruments to createhighly sophisticated risk transfer strategies tailored for a corporate client’s
speciﬁc needs and liability structure that traditional insurance cannot han-
dle.
8For this reason, ART is sometimes referred to as “insurance-based
investment banking.”
An example of one type of ART is an insurance-linked note (ILN).

This type of ART has been primarily used by life insurers and propertyand casualty insurers to bypass the conventional reinsurance market and
synthetically reinsure against losses by tapping the capital markets. Basically,
an ILN is a means for securitizing insurance risk and is typically referred to
ascatastrophe-linked bonds or simply cat bonds.
The ﬁrst use of catastrophe-linked bonds in corporate risk management

by a noninsurance company was by the owner-operator of Tokyo Disney-land, Oriental Land Co. Rather than obtain traditional insurance against
8For a detailed discussion of ART, see Christopher L. Culp, Structured Finance and
Insurance: The ART of Managing Capital and Risk (Hoboken, NJ: John Wiley &
Sons, 2006) and Erik Banks, Alternative Risk Transfer: Integrated Risk Manage-
ment Through Insurance, Reinsurance and the Capital Markets (Hoboken, NJ: John
Wiley & Sons, 2004).

Financial Risk Management 197
earthquake damage for the park, it issued a $200 million cat bond in 1999.
Three years later, Vivendi Universal obtained protection for earthquakedamage for its studios (Universal Studios) in California by issuing a $175
million cat bond with a maturity of 3.5 years.
Whereas catastrophe-linked bonds have primarily been used for perils

such as earthquakes and hurricanes, corporations are using them in otherways. For example, the risk to the lessor (i.e., the owner of the leased
equipment) in a leasing transaction is that the value of the leased equipmentwhen the lease terminates (the residual value) is below its expected value
when the lease was negotiated.
CASE IN POINT: CAT BONDS
Toyota Motor Credit Corp. was concerned that the 260,000 1998
motor vehicles (cars and light-duty trucks) it leased to customers would

decline in value if the used-car market weakened. To protect itself,
Toyota issued a cat bond that provided protection for itself against aloss in market value of the ﬂeet of leased motor vehicles.
Structured Finance Structured ﬁnance involves the creation of
nontraditional-type securities with risk and return proﬁles targeted to certaintypes of investors. Structured ﬁnance includes asset securitization, structurednotes, and leasing.

■Financial risk management involves identifying and measuring risk, as
well as determining how much, if any, risk to retain.
■We can categorize risks as core risks and noncore risks. The core risks
are business risks, those risks that the company is in the business to
bear. Noncore risks are risks that are incidental to the operations of a
business.
■Sustainability risk is the extension of traditional business and ﬁnancial

risks to the complete spectrum of risk that a company faces that includes
social and environmental responsibilities.
■Enterprise risk management is the holistic approach to risk manage-
ment, where risk is managed from the perspective of the entire entity or

198 INVESTMENTS
■An entity can decide whether to retain risk, neutralize it, or transfer it
to another party.
■Retained risks are the aggregate of all the risks across the company that
a company’s management has elected to bear. Because management
decides to fund or not fund a retained risk, management of retained riskis referred to as risk ﬁnance.

■Risk neutralization is a risk management policy whereby a companyacts on its own to mitigate the outcome of an expected loss from anidentiﬁed risk without transferring that risk to a third party.
■Risk transfer management involves transferring certain identiﬁable risksfrom shareholders to a third party either by entering into a contract witha counterparty willing to take on the risk the company seeks to transfer
or by embedding that risk in a structured ﬁnancial transaction.
QUESTIONS

QUESTIONS
1.What is the difference between core and no-core risk?
2.How does the theory of portfolio risk relate to enterprise risk
management?
3.What is meant by sustainability risk?
4.What are the three choices available to management for dealing withrisk?
5.What distinguishes an unfunded from a funded retained risk?
6.What is the function of an insurance-linked note for risk management?
7.What methods can a company use to transfer risk?
8.How does a core risk differ from a non core risk?

9.How can derivatives be used in risk management?
10.What is a cat bond and how can it be used to manage risk?
11.The following “Company Overview” of AIG Risk Finance was de-scribed on the Internet (investing.businessweek.com/research/stocks/
private/snapshot.asp?privcapId=11673577):
AIG Risk Finance designs and implements risk ﬁnancing solu-tions. The company offers structured insurance, exotic buyouts,
and unconventional life programs. ...AIG Risk Finance oper-

ates as a subsidiary of American International Group, Inc.
a.What is meant by “structured insurance”?
b.What is an alternative name for structured insurance?
c.Give two examples of structured insurance.

c10 JWBT310-Fabozzi July 8, 2010 13:9 Printer: Courier Westford, Westford, MA
PARTThree
Valuation and
Analytical Tools
199

200

CHAPTER10
The Math of Finance
The price then that the borrower has to pay for the loan of capital,
and which he regards as interest, is from the point of view of the
lender more properly to be regarded as proﬁts: for it includes
insurance against risks which are often very heavy, and earnings ofarrangement for the task, which is often very arduous, of keeping

those risks as small as possible. Variations in the nature of these
risks and of the task of management will of course occasioncorresponding variations in the gross interest—so called that is
paid of the use of money.
—Alfred Marshall, Principles of Economics: Volume 2
(London: MacMillan & Co., 1890), p. 623
Investment decisions made by ﬁnancial managers, to acquire capital assetssuch as plant and equipment, and asset managers, to acquire securities

such as stocks and bonds, require the valuation of investments and the
determination of yields on investments. The concept that must be understood
to determine the value of an investment, the yield on an investment, and
the cost of funds is the time value of money. This simple mathematicalconcept allows ﬁnancial and asset managers to translate future cash ﬂows
to a value in the present, translate a value today into a value at some future

point in time, and calculate the yield on an investment. The time-value-of-money mathematics allows an evaluation and comparison of investments
and ﬁnancing arrangements and is the subject of this chapter.
WHY THE TIME VALUE OF MONEY?
The notion that money has a time value is one of the most basic concepts
in investment analysis. Making decisions today regarding future cash ﬂows
201

202 VALUATION AND ANALYTICAL TOOLS
requires understanding that the value of money does not remain the same
throughout time.
A dollar today is worth less than a dollar at some future for two reasons:
Reason 1: Cash ﬂows occurring at different times have different values
relative to any one point in time.
One dollar one year from now is not as valuable as one dollar

today. After all, you can invest a dollar today and earn interest so
that the value it grows to next year is greater than the one dollar
today. This means we have to take into account the time value
of money to quantify the relation between cash ﬂows at different
points in time.
Reason 2: Cash ﬂows are uncertain.
Expected cash ﬂows may not materialize. Uncertainty stems

from the nature of forecasts of the timing and the amount of cashﬂows. We do not know for certain when, whether, or how muchcash ﬂows will be in the future. This uncertainty regarding future
cash ﬂows must somehow be taken into account in assessing the
value of an investment.
Translating a current value into its equivalent future value is compound-
ing. Translating a future cash ﬂow or value into its equivalent value in a prior

period is discounting . In this chapter, we outline the basic mathematical
techniques of compounding and discounting.
Suppose someone wants to borrow $100 today and promises to pay
back the amount borrowed in one month. Would the repayment of onlythe $100 be fair? Probably not. There are two things to consider. First, ifthe lender didn’t lend the $100, what could he or she have done with it?
Second, is there a chance that the borrower may not pay back the loan? So,

when considering lending money, we must consider the opportunity cost
(that is, what could have been earned or enjoyed), as well as the uncertainty
associated with getting the money back as promised.
Let’s say that someone is willing to lend the money, but that they require
repayment of the $100 plus some compensation for the opportunity cost andany uncertainty the loan will be repaid as promised. Then:
■the amount of the loan, the $100, is the principal; and

■the compensation required for allowing someone else to use the $100 isthe interest.
Looking at this same situation from the perspective of time and value,
the amount that you are willing to lend today is the loan’s present value.
The amount that you require to be paid at the end of the loan period is

The Math of Finance 203
the loan’s future value. Therefore, the future period’s value is comprised of
two parts:
Amount paid at the
end of the loan Principal Interest
/barb2down/barb2down /barb2down
Future value =Present value + Interest
or, using notation,
FV = PV +(i×PV)
If you would know the value of money, go and try to borrow some.

The interest is compensation for the use of funds for the period of the
loan. It consists of:
1.compensation for the length of time the money is borrowed; and
2.compensation for the risk that the amount borrowed will not be repaid
exactly as set forth in the loan agreement.
CALCULATING THE FUTURE VALUE
Suppose you deposit $1,000 into a savings account at the Safe Savings Bankand you are promised 5% interest per period. At the end of one period, you

would have $1,050. This $1,050 consists of the return of your principalamount of the investment (the $1,000) and the interest or return on your
investment (the $50). Let’s label these values:
■$1,000 is the value today, the present value, PV.
■$1,050 is the value at the end of one period, the future value, FV.
■5% is the rate interest is earned in one period, the interest rate, i.
To get to the future value from the present value:
FV =PV +Interest
FV =PV +PV×i
FV =PV ×(1+i)

$1,050 =$1,000 ×(1.05)

204 VALUATION AND ANALYTICAL TOOLS
If the $50 interest is withdrawn at the end of the period, the principal is
left to earn interest at the 5% rate. Whenever you do this, you earn simple
interest . It is simple because it repeats itself in exactly the same way from
one period to the next as long as you take out the interest at the end of each
period and the principal remains the same.

Time is money.
If, on the other hand, both the principal and the interest are left on
deposit at the Safe Savings Bank, the balance earns interest on the previouslypaid interest, referred to as compound interest . Earning interest on interest
is called compounding because the balance at any time is a combination ofthe principal, interest on principal, and interest on accumulated interest (or
simply, interest on interest ).

If you compound interest for one more period in our example, the
original $1,000 grows to $1,052.50:
FV=Principal +First period interest +Second period interest
=PV +PV×i +[PV(1+i)]×i
=$1,000.00 +($1,000.00 ×0.05) +($1,050.00 ×0.05)
=$1,000.00 +50.00 +52.50
=$1,052.50
The present value of the investment is $1,000, theinterest earned over

two years is $52.50, and the future value of the investment after two yearsis $1,052.50. If this were simple interest, the future value would be $1,050.
Therefore, the interest on interest—the results of compounding—is $2.50.
We can use some shorthand to represent the FV at the end of two
periods:
FV=PV(1+i)
2
The balance in the account two years from now, $1,052.50, is comprised
of three parts:
■The principal, $1,000.
■Interest on principal: $50 in the ﬁrst period plus $50 in the second

period.
■Interest on interest: 5% of the ﬁrst period’s interest, or 0.05 ×$50=
$2.50.

The Math of Finance 205
To determine the future value with compound interest for more than
two periods, we follow along the same lines:
FV=PV(1+i)N(10.1)
The value of Nis the number of compounding periods, where a com-
pounding period is the unit of time after which interest is paid at the rate i.
A period may be any length of time: a minute, a day, a month, or a year.

The important thing is to be consistent through the calculations. The term“(1+i)
N”i st h ecompound factor , and it is the rate of exchange between
present dollars and future dollars, ncompounding periods into the future.
The entire essence of America is the hope to ﬁrst make money—then make money with money—then make lots of money with lots
of money.
—Paul Erdman
Equation (10.1) is the foundation of ﬁnancial mathematics. It relates a

value at one point in time to a value at another point in time, considering
the compounding of interest.
We show the relation between present and future values for a principal
of $1,000 and interest of 5% per period through 10 compounding periodsin Exhibit 10.1. For example, the value of $1,000, earning interest at 5%per period, is $1,628.89, which is 10 periods into the future:
FV=$1,000(1 +0.05)
10=$1,000(1.62898) =$1,628.89

After ten years, there will be $1,628.89 in the account, consisting of:
■The principal, $1,000;
■Interest on the principal of $1,000: $50 per period for 10 periods or
$500; and
■Interest on interest totaling $128.89.
If you left the money in the bank, after 50 years you would have:
FV=$1,000(1 +0.05)50=$11,467.40
If this were simple interest instead of compound interest, the balance
after 50 years would be: $1,000 +[50×$1,000 ×0.05] =$3,500. In

other words, the $11,467.40 – 3,500 =$7,967.40. This is the power of
compounding.

206 VALUATION AND ANALYTICAL TOOLS
Value at the End of the Period
Number of Compound Periods
EXHIBIT 10.1 The Future Value of $1,000 Invested for 10 Years in an Account
That Pays 10% Compounded Interest per Year
We can use ﬁnancial calculators, scientiﬁc calculators with ﬁnancial
functions, or spreadsheets to solve most any ﬁnancial problem. Consider the

problem of calculating the future value of $1,000 at 5% for 10 years:
Hewlett-Packard
10BTexas Instruments83/84 Microsoft Excel
1000 +/− PV
10 N5I / Y R
PVN=10
I%=5
PV=−1000
Place cursor at FV=
and then SOLVE=FV(.05,10,0,−1000)
A few notes about entering the data into the calculator or spreadsheet:
1.You need to change the sign of the present value to negative, reﬂecting
the investment (negative cash ﬂow).
2.You enter interest rates as whole values form when using the ﬁnancial

functions within a calculator, but enter these in decimal form if us-
ing the math functions of a calculation or the ﬁnancial functions of a
spreadsheet.

The Math of Finance 207
3.If you are using the ﬁnancial function of a scientiﬁc calculator, you need
to ﬁrst enter this function. In the case of the Texas Instruments 83 or84 calculator, for example, this is done through APPS >Finance>TVM
Solver.
4.If you are using a spreadsheet function, you must enter a 0 in place ofan unused argument.
1
EXAMPLE 10.1: GUARANTEED
INVESTMENT CONTRACTS

1
A common investment product of a life insurance company is a guar-
anteed investment contract (GIC). With this investment, an insurance
company guarantees a speciﬁed interest rate for a period of years.
Suppose that the life insurance company agrees to pay 6% annuallyfor a ﬁve-year GIC and the amount invested by the policyholder is
$10 million.
The amount of the liability (that is, the amount this life insurance

company has agreed to pay the GIC policyholder) is the future valueof $10 million when invested at 6% interest for ﬁve years:
PV=$10,000,000, i=6%, andN=5,
so that the future value is
FV=$10,000, 000(1 +0.06)
5=$13,382,256
TRY IT! FUTURE VALUE
If you deposit $100 in a saving account that pays 2% interest per year,compounded annually, how much will you have in the account at the
end of
a.ﬁve years?
b.10 years?
c.20 years?

end of
1For example, the FV function has the following arguments: interest rate, number of
periods, payment, and present value. Because this last problem does not involve any
periodic payments, we used a zero for that argument.

208 VALUATION AND ANALYTICAL TOOLS
Growth Rates and Returns
We can express the change in the value of the savings balance as a growth
rate. A growth rate is the rate at which a value appreciates (a positive

growth) or depreciates (a negative growth) over time. Our $1,000 grew ata rate of 5% per year over the 10-year period to $1,628.89. The averageannual growth rate of our investment of $1,000 is 5%—the value of the
savings account balance increased 5% per year.
We could also express the appreciation in our savings balance in terms
of a return. A return is the income on an investment, generally stated as
a change in the value of the investment over each period divided by the

amount at the investment at the beginning of the period. We could also say
that our investment of $1,000 provides an average annual return of 5% per
year. The average annual return is not calculated by taking the change invalue over the entire 10-year period ($1,629.89 −$1,000) and dividing it
by $1,000. This would produce an arithmetic average return of 62.889%

over the 10-year period, or 6.2889% per year. But the arithmetic averageignores the process of compounding, so this is not the correct annual return.
The correct way of calculating the average annual return is to use a
geometric average return :
Geometric average return =
N√
FV
PV−1 (10.2)
which is a rearrangement of equation (10.1). Using the values from theexample,
Geometric average return =10√
$1,628 .89
$1,000.00−1=5%
Therefore, the annual return on the investment as the compound average

annual return or the true return—is 5% per year.
Hewlett-Packard10BTexas Instruments83/84 Microsoft Excel
1000 +/− PV
10 N1628.89 FV
I/YRN=10
PV=−1000
FV=1628.89
Place cursor at
I%=and then
SOLVE=RATE(10,0,−1000,1628.89)

The Math of Finance 209
TRY IT! GROWTH RATES
Suppose you invest $2,000 today and you double your money after
ﬁve years. What is the annual growth rate on your investment?
Compounding More Than Once per Year
An investment may pay interest more than one time per year. For example,interest may be paid semiannually, quarterly, monthly, weekly, or daily, even

though the stated rate is quoted on an annual basis. If the interest is stated
as, say, 4% per year, compounded semiannually, the nominal rate—oftenreferred to as the annual percentage rate (APR)—is 4%.
Suppose we invest $10,000 in an account that pays interest stated at a
rate of 4% per year, with interest compounded quarterly. How much will we
have after ﬁve years if we do not make any withdrawals? We can approach

problems when compounding is more frequent than once per year using twodifferent methods:
Method 1: Convert the information into compounding periods and solve
The inputs:
PV=$10,000
N=5×4=20
i=4%÷4=1%
Solve for FV:
FV=$10,000 (1 +0.01)
20=$12,201.90
Method 2: Convert the APR into an effective annual rate and solve
N=5
i=(1+0.01)4−1=4.0604%
FV=$10,000 (1 +0.040601)5=$12,201.90
Both methods will get you to the correct answer. In Method 1, you

need to adjust both the number of periods and the rate. In Method 2, you
need to ﬁrst calculate the effective annual rate, in this case 4.0601%, beforecalculating the future value.

210 VALUATION AND ANALYTICAL TOOLS
Compounding
frequencyCompound
periodRate per
compound
periodNumber of
compound periods
in 10 yearsFuture
value
Annual 1 year 8% 10 $215.89
Semiannual 6 months 4% 20 $219.11
Quarterly 3 months 2% 40 $220.80
Monthly 1 month 0.67% 120 $221.96
$6,000
Monthly Annual
$1,000
$0
04 1 2 10 16 20
Number of YearsFuture Value

$0
24 28 32 36 40 44 48$2,000$3,000$4,000$5,000
EXHIBIT 10.2 Value of $100 Invested in the Account That Pays 8% Interest
per Year for 10 Years for Different Frequencies of Compounding
The frequency of compounding matters. To see how this works, let’s
use an example of a deposit of $100 in an account that pays interest at a

rate of 8% per year, with interest compounded for different compoundingfrequencies. How much is in the account after, say, 10 years depends on
the compounding frequency, as we show in Exhibit 10.2. At the end of
ten years, the difference in the future values between annual and monthly
compounding is a little more than $6. After 50 years, the difference is $5,388
– 4,690 =$698.
EXAMPLE 10.2: QUARTERLY COMPOUNDING

Suppose we invest $200,000 in an investment that pays 4% interestper year, compounded quarterly. What will be the future value of this
investment at the end of 10 years?

The Math of Finance 211
Solution:
The given information is:
i=4%/4 =1% and N=10×4=40 quarters .
Therefore, FV=$200,000(1 +0.01)40=$297,772.75
TRY IT! MORE GROWTH RATES
Complete the following table, calculating the annual growth rate for
each investment.
Present Value Future Value Number of Years Growth Rate
$1 $3 6
$1,000 $2,000 9
$500 $600 7
$1 $1.50 4
Continuous Compounding

$500 $600 7
$1 $1.50 4
The extreme frequency of compounding is continuous compounding —
interest is compounded instantaneously. The factor for compounding con-tinuously for one year is e
APR, where eis 2.71828 ..., the base of the natural
logarithm. And the factor for compounding continuously for two years ise
APR×eAPRore2APR. The future value of an amount that is compounded
continuously for Nyears is
FV=PVeN(APR)(10.3)

where APR is the annual percentage rate and eN(APR)is the compound
factor.

212 VALUATION AND ANALYTICAL TOOLS
If $1,000 is deposited in an account for ﬁve years, with interest of 12%
per year, compounded continuously,
FV=$1,000e5(0.12)
=$1,000(e0.60)
=$1,000×1.82212
=$1,822.12
Comparing this future value with that if interest is compounded annually
at 12% per year for ﬁve years, $1,000 (1 +0.12)5=$1,762.34, we see the

effects of this extreme frequency of compounding.
This process of growing proportionately, at every instant, to the
magnitude at that instant, some people call a logarithmic rate of
growing. Unit logarithmic rate of growth is that rate which in unittime will cause 1 to grow to 2.718281.
It might also be called the organic rate of growing: because it
is characteristic of organic growth (in certain circumstances) that
the increment of the organism in a given time is proportional to the

magnitude of the organism itself.
—Silvanus P. Thompson, Calculus Made Easy
(London: MacMillan and Co. Limited, 1914), p. 140
TRY IT! FREQUENCY OF COMPOUNDING
If you deposit $100 in a saving account today that pays 2% interest
per year, how much will you have in the account at the end of 10 years
if interest is compounded:
a.annually?
b.quarterly?
c.continuously?
Multiple Rates
In our discussion thus far, we have assumed that the investment will earn

the same periodic interest rate, i. We can extend the calculation of a future
value to allow for different interest rates or growth rates for different periods.

The Math of Finance 213
Suppose an investment of $10,000 pays 5% during the ﬁrst year and 4%
during the second year. At the end of the ﬁrst period, the value of theinvestment is $10,000 (1 +0.05), or $10,500. During the second period,
this $10,500 earns interest at 4%. Therefore, the future value of this $10,000at the end of the second period is
FV=$10,000 (1 +0.05) (1 +0.4)=$10,920

We can write this more generally as:
FV=PV(1+i
1)(1+i2)(1+i3)...(1+iN) (10.4)
where iNis the interest rate for period N.
EXAMPLE 10.3: DIFFERENT INTEREST RATES
FOR DIFFERENT PERIODS
Consider a $50,000 investment in a one-year bank certiﬁcate of deposit
(CD) today and rolled over annually for the next two years into one-
year CDs. The future value of the $50,000 investment will depend on
the one-year CD rate each time the funds are rolled over. Assume that

the one-year CD rate today is 5% and that it is expected that the one-year CD rate one year from now will be 6%, and the one-year CD rate
two years from now will be 6.5%.
a.What is the future value of this investment at the end of three
years?
b.What is the average annual return on your CD investment?
Solution
a.FV=$50,000(1 +0.05)(1 +0.06)(1 +0.065) =$59,267.25
b.i=
3√
$59, 267.25
$50, 000−1=5.8315%
CALCULATING A PRESENT VALUE
Now that we understand how to compute future values, let’s work the

process in reverse. Suppose that for borrowing a speciﬁc amount of money
today, the Trustworthy Company promises to pay lenders $5,000 two years

214 VALUATION AND ANALYTICAL TOOLS
from today. How much should the lenders be willing to lend Trustworthy
in exchange for this promise? This dilemma is different than calculating afuture value. Here we are given the future value and have to calculate the
present value. But we can use the same basic idea from the future value
problems to solve present value problems.

If you can earn 5% on other investments that have the same amount of
uncertainty as the $5,000 Trustworthy promises to pay, then:
■The future value, FV=$5,000.
■The number of compounding periods, N=2.
■The interest rate, i=5%.
We also know the basic relation between the present and future values:
FV=PV(1+i)N
Substituting the known values into this equation:
$5,000=PV(1+0.05)2
To determine how much you are willing to lend now, PV, to get $5,000

one year from now, FV, requires solving this equation for the unknown
present value:
$5,000 =PV(1+0.05)2
Therefore, you would be willing to lend $4,535.15 to receive $5,000
one year from today if your opportunity cost is 5%. We can check ourwork by reworking the problem from the reverse perspective. Suppose youinvested $4,535.15 for two years and it earned 5% per year. What is the
value of this investment at the end of the year?

We know: PV=$4,535.15.25, N=5% or 0.05, and i=2. Therefore,
the future value is $5,000:
N=$4,535.15(1 +0.05)2=$5,000.00
Compounding translates a value in one point in time into a value at
some future point in time. The opposite process translates future values intopresent values: Discounting translates a value back in time. From the basic
valuation equation,
N

N
we divide both sides by (1 +i)Nand exchange sides to get the present value,
PV=FV
(1+i)N=FV(1
1+i)N
=FV[1
(1+i)N]
(10.5)

The Math of Finance 215
$5,000.00
$4,761.90
$4,535.15
$4,319.19
$4,113.15 
$3,917.63
$3,731.08
$3,553.41
$3,384.20
$3,223.04
$3,069.57
$2,923.40
$2,784.19
$2,651.61
$2,525.34
$2,405.09
$0$1,000$2,000$3,000$4,000$5,000
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Number of Discount PeriodsPresent Value
EXHIBIT 10.3 Present Value of $5,000 for 0 to 15 Periods, at a
Discount Rate of 5% per Period

In the right-most form, the term in square brackets is referred to as the
discount factor since it is used to translate a future value to its equivalent
present value. We can restate our problem as:
PV=$5,000
(1+0.05)2=$5,000[1
(1+0.05)2]
=$5,000 ×0.90703
=$4,535.15,
where the discount factor is 0.90703. We provide the present value of $5,000
for discount periods ranging from 0 to 15 in Exhibit 10.3.

We can also calculate this present using a calculator or a spreadsheet.
Consider the present value of the $5,000 at 5% for ten years:
5000 FV
10 N
5I / Y R
PVN=10
FV=5000
I%=5
Place cursor at I% =
and then SOLVE=PV(.05,10,0,5000)
If the frequency of compounding is greater than once a year, we make

adjustments to the rate per period and the number of periods as we didin compounding. For example, if the future value ﬁve years from todayis $100,000 and the interest is 6% per year, compounded semiannually,

216 VALUATION AND ANALYTICAL TOOLS
i=6%÷2=3%, N=5×2=10, and the present value is $134,392:
PV=$100, 000(1 +0.03)10=$100, 000×1.34392 =$134, 392
TRY IT! PRESENT VALUE
You are presented with an investment that promises $1,000 in ten
years. If you consider the appropriate discount rate to be 6%, basedon what you can earn on similar risk investments, what would you be

willing to pay for this investment today?
EXAMPLE 10.4: MEETING A SAVINGS GOAL
Suppose that the goal is to have $75,000 in an account by the endof four years. And suppose that interest on this account is paid at a
rate of 5% per year, compounded semiannually. How much must bedeposited in the account today to reach this goal?
Solution
We are given FV=$75,000, i=5%×2=2.5% per six months,
andN=4×2=8 six-month periods. Therefore, the amount of the
required deposit is:
PV=$75,000

(1+0.025)8=$61,555.99
DETERMINING THE UNKNOWN INTEREST RATE
As we saw earlier in our discussion of growth rates, we can rearrange the
basic equation to solve for i:
i=N√
FV
PV−1

The Math of Finance 217
which is the same as:
i=(FV/PV)1/N−1
As an example, suppose that the value of an investment today is $2,000
and the expected value of the investment in ﬁve years $3,000. What is the
annual rate of appreciation in value of this investment over the ﬁve-yearperiod?
i=5√
$3,000
$2,000−1=8.447%
There are many applications in ﬁnance where it is necessary to determine

the rate of change in values over a period of time. If values are increasing overtime, we refer to the rate of change as the growth rate. To make comparisons
easier, we usually specify the growth rate as a rate per year.
EXAMPLE 10.5: INTEREST RATES
Consider the growth rate of dividends for General Electric. General
Electric pays dividends each year. In 1996, for example, General Elec-
tric paid dividends of $0.317 per share of its common stock, whereas

in 2006 the company paid $1.03 in dividends per share in 2006.
Solution
This represents a growth rate of 12.507%:
i=10√
$1.03
$0.317−1=12.507%
THE TIME VALUE OF A SERIES OF CASH FLOWS
Applications in ﬁnance may require determining the present or future value
of a series of cash ﬂows rather than simply a single cash ﬂow. The principlesof determining the future value or present value of a series of cash ﬂows
are the same as for a single cash ﬂow, yet the math becomes a bit more
cumbersome.

218 VALUATION AND ANALYTICAL TOOLS
Suppose that the following deposits are made in a Thrifty Savings and
Loan account paying 5% interest, compounded annually:
PeriodEnd of Period
Cash Flow
0 $1,000
1 $2,000
2 $1,500
What is the balance in the savings account at the end of the second year
if there are no withdrawals and interest is paid annually?

Let’s simplify any problem like this by referring to today as the end of
period 0, and identifying the end of the ﬁrst and each successive period as
1, 2, 3, and so on. Represent each end-of-period cash ﬂow as CFwith a
subscript specifying the period to which it corresponds. Thus, CF0is a cash
ﬂow today, CF10is a cash ﬂow at the end of period 10, and CF25is a cash
ﬂow at the end of period 25, and so on. In our example, CF0is $1,000, CF1
is $2,000, and CF2is $1,500.

Representing the information in our example using cash ﬂow and period
notation:
FV=CF0(1+i)2+CF1(1+i)1+CF2(1+i)0
It is important to get the compounding correct. For example, there is no
compounding of the cash ﬂow that occurs at the end of the second period
to arrive at a future value at the end of the second period. Hence, the factoris (1+i)
0=1.
We can represent these cash ﬂows in a time line in Exhibit 10.4 to help

graphically depict and sort out each cash ﬂow in a series. From this example,you can see that the future value of the entire series is the sum of each of the
EXHIBIT 10.4
Time Line for the Future Value of a Series of Uneven Cash Flows
Deposited to Earn 5% Compound Interest per Period
01 2
|| |
|| |
$1,000.00 $2,000.00 $1,500.00
/arrowdwnrt1 $2,000 (1 +0.05) =2,100.00
/arrowdwnrt1 $1,000.00 (1 +0.05)2= 1,102.50
$4,702.50

The Math of Finance 219
compounded cash ﬂows comprising the series. In much the same way, we
can determine the future value of a series comprising any number of cashﬂows. And if we need to, we can determine the future value of a number of
cash ﬂows before the end of the series.
To determine the present value of a series of future cash ﬂows, each cash

ﬂow is discounted back to the present, where we designate the beginning ofthe ﬁrst period, today, as 0. As an example, consider the Thrifty Savings &
Loan problem from a different angle. Instead of calculating what the depositsand the interest on these deposits will be worth in the future, let’s calculate
the present value of the deposits. The present value is what these future
deposits are worth today.
Suppose you are promised the following cash ﬂows:
Period Cash FlowEnd of Period
Cash Flow

Cash Flow
0 CF0 $1,000
1 CF1 $2,000
2 CF2 $1,500
What is the present value of these cash ﬂows—that is, at the end of
period 0—if the discount rate is 5%? We would use the same method
that we used in the previous problem—just backwards. We show this in
Exhibit 10.5. As you can see in this exhibit, we don’t discount the cash ﬂowthat occurs today. We discount the ﬁrst period’s cash ﬂow one period, and
discount the second period’s cash ﬂow two periods.
EXHIBIT 10.5

Time Line for the Present Value of a Series of Uneven Cash Flows
Deposited to Earn 5% Compounded Interest per Period
01 2
|| |
|| |
1,904.76$2,000
(1+0.05)/arrowdwnleft1
1,360.54$1,500
(1+0.05)2/arrowdwnleft1
$4,265.30

220 VALUATION AND ANALYTICAL TOOLS
You may also notice a relation between the future value that we cal-
culated in Exhibit 10.4 and the present value that we calculated in Ex-
hibit 10.5, with both examples using the same set of cash ﬂows and same
interest rate—just going in different directions:
$4,265.30 (1 +0.05)2=$4,702.50
Gettin’ Fancy

We can represent the future value of a series of cash ﬂows as:
FV=N∑
t=0CFt(1+i)N−t(10.6)
This, simply, means that the future value of a series of cash ﬂows is the
sum of the future value of each cash ﬂow, where each of the future valueconsiders the amount of the cash ﬂow and the number of compounding
period. Therefore, if there are 10 periods, the cash ﬂow from occurring atthe end of the sixth period, CF
6, would have interest compounded N−t=

10−6=4 periods, and the cash ﬂow occurring at the end of the tenth
period would not have any compounding.
And, likewise, we can represent the present value of a series using sum-
mation notation as:
PV=N∑
t=0CFt
(1+i)t(10.7)
with a similar explanation. For example, the cash ﬂow occurring at the endof the ﬁfth period is discounted ﬁve periods at the discount rate of i.

In our illustrations thus far, we have used one interest rate to compute thepresent value of all cash ﬂows in a series. However, there is no reason that
one interest rate must be used. For example, suppose that the cash ﬂow is
the same as used earlier: $1,000 today, $2,000 at the end of period 1, and$1,500 at the end of period 2. Now, instead of assuming that a 5% interest
rate can be earned if a sum is invested today until the end of period 1 and the

end of period 2, it is assumed that an amount invested today for one periodcan earn 5% but an amount invested today for two periods can earn 6%.
In this case, the calculation of the present value of the cash ﬂow at
the end of period 1 (the $2,000) is obtained in the same way as before:computing the present value using an interest rate of 5%. However, we

The Math of Finance 221
EXHIBIT 10.6 Time Line for the Present Value of a Series of Uneven Cash Flows
01 2
|| |
|| |
1,334.99$1,500
(1+0.06)2/arrowdwnleft1
$4,239.75
must calculate the present value for the cash ﬂow at the end of period 2 (the

$1,500) using an interest rate of 6%. We depict the present value calculation
in Exhibit 10.6. As expected, the present value of the cash ﬂows is less than a5% interest rate is assumed to be earned for two periods ($4,239.75 versus
$4,265.39).
Although in many illustrations and applications throughout this book
we will assume a single interest rate for determining the present value of aseries of cash ﬂows, in many real-world applications multiple interest rates

are used. This is because in real-world ﬁnancial markets the interest rate thatcan be earned depends on the amount of time the investment is expected to
be outstanding. Typically, there is a positive relationship between interest
rates and the length of time the investment must be held. The relationshipbetween interest rates on investments and the length of time the investment
must be held is called the yield curve.
The formula for the present value of a series of cash ﬂows when there

is a different interest rate is a simple modiﬁcation of the single interest rate
case. In the formula, iis replaced by iwith a subscript to denote the period,
i
t. That is,
PV=N∑
t=0CFt
(1+it)t
ANNUITIES
There are valuation problems that require us to evaluate a series of levelcash ﬂows—each cash ﬂow is the same amount as the others—received atregular intervals. Let’s suppose you expect to deposit $2,000 at the end of

222 VALUATION AND ANALYTICAL TOOLS
EXHIBIT 10.7 Time Line for a Series of Even Cash Flows Deposited to Earn
5% Interest per Period
A: Future Value
01234
|||||
||||
$2,000.00 $2,000.00 $2,000.00 $2,000.00
/arrowdwnrt1 2,100.00
/arrowdwnrt1 2,205.00
/arrowdwnrt1 2,315.25
$8,620.25
B: Present Value
01234
|||||
||||
$1,904.76 /arrowdwnleft1

1,814.06 /arrowdwnleft1
1,727.68 /arrowdwnleft1
1,645.40 /arrowdwnleft1
$7,091.90
each of the next four years in an account earning 8% compounded interest.
How much will you have available at the end of the fourth year?
As we just did for the future value of a series of uneven cash ﬂows,
we can calculate the future value (as of the end of the fourth year) of each$2,000 deposit, compounding interest at 5%, as we show in Exhibit 10.7.

The future value of this series is $8,620.25. Modifying the future value of a
series equation to reﬂect that all of the cash ﬂows are the same,
FV= N∑
t=0CF(1+i)N−t=CFN∑
t=0(1+i)N−t(10.8)
A series of cash ﬂows of equal amount, occurring at even intervals is
referred to as an annuity. Determining the value of an annuity, whether
compounding or discounting, is simpler than valuing uneven cash ﬂows.
Consider the same series of $2,000 for four periods, but calculate

the present value of the series. We show this calculation in Panel B ofExhibit 10.7. The present value of this series is $7,091.90.

The Math of Finance 223
EXAMPLE 10.6: FUTURE VALUE OF AN ANNUITY
Suppose you wish to determine the future value of a series of deposits
of $1,000, deposited each year in the No Fault Vault Bank for ﬁve
years, with the ﬁrst deposit made at the end of the ﬁrst year. If the

NFV Bank pays 5% interest on the balance in the account at the endof each year and no withdrawals are made, what is the balance in the
account at the end of the ﬁve years?
Solution
In equation form,
FV=$1,000 5∑
t=1(1+0.05)N−t=$1,000(5.5263) =$5,525.63
Summing the individual future values:
Cash Flow Amount Future Value
CF1 $1,000 $1,215.51
CF2 $1,000 1,157.63
CF3 $1,000 1,102.50
CF4 $1,000 1,050.00
CF5 $1,000 1.000.00
Total $5,525.63

Calculator and spreadsheet inputs:Periodic payment =PMT =1,000
i=5% (input as 5 for calculator, 0.05 for spreadsheet)
N=5
Solve for FV
As we did with the future valueof an even series, we can simplify the
equation for the present value of a series of level cash ﬂows beginning after
one period as:
PV=N∑
t=0CF
(1+i)t=CFN∑
t=01
(1+i)t(10.9)

224 VALUATION AND ANALYTICAL TOOLS
EXHIBIT 10.8 Time Line for a Series of Even Cash Flows Deposited to Earn
4% Interest per Period
A: Future Value of the Ordinary Annuity
0123 4
|||| |
||| |
$500.00 $500.00 $500.00 $500.00
/arrowdwnrt1 520.00
/arrowdwnrt1 540.80
/arrowdwnrt1 562.43
$2,123.23
B: Future Value of the Annuity Due
0123 4
|||| |
||| |

|||| |
||| |
/arrowdwnrt1 $520.00
584.93
$2,208.16
Another way of looking at this is that the present value of an annuity is
equal to the amount of one cash ﬂow multiplied by the sum of the discount
factors.
If the cash ﬂows occur at the end of each period (that is, the ﬁrst cash ﬂow
occurs one period from today), we refer to this as an ordinary annuity.T h e

two examples that we provide in Exhibit 10.8 are both ordinary annuities.
EXAMPLE 10.7: PRESENT VALUE OF AN ANNUITY
Consider a ﬁve-payment annuity, with payments of $500 at the end of
each of the next ﬁve years.
a.If the appropriate discount rate is 4%, what is the present value of
this annuity?
b.If the appropriate discount rate is 5%, what is the present value of

The Math of Finance 225
Solution
a.Given: PMT=$500; i=4%;N=5. Solve for PV.PV=$2,225.91
b.Given: PMT=$500, i=4%,N=5. Solve for PV.PV=$2,164.74
Note: The higher the discount rate, the lower the present value of
the annuity.
Equations (10.8) and (10.9) are the valuation—future and present
value—formulas for an ordinary annuity. An ordinary annuity is there-

fore a special form of annuity, where the ﬁrst cash ﬂow occurs at the
end of the ﬁrst period.
This annuity short-cut is built into ﬁnancial calculators and spread-
sheet functions. For example, in the case of the present value of thefour-payment ordinary annuity of $2,000 at 5%:
2000 PMT
4N
5I / Y RPVN=4
I%=5
PMT =2000
FV=0
Place cursor at PV=
and then SOLVE=PV(.05,4,2000,0)
Valuing a Perpetuity

There are some circumstances where cash ﬂows are expected to continueforever. For example, a corporation may promise to pay dividends on pre-
ferred stock forever, or, a company may issue a bond that pays interest every
six months, forever. How do you value these cash ﬂow streams? Recall thatwhen we calculated the present value of an annuity, we took the amount
of one cash ﬂow and multiplied it by the sum of the discount factors that

corresponded to the interest rate and number of payments. But what if thenumber of payments extends forever—into inﬁnity?
A series of cash ﬂows that occur at regular intervals, forever, is a perpe-
tuity. Valuing a perpetual cash ﬂow stream is just like valuing an ordinary

226 VALUATION AND ANALYTICAL TOOLS
annuity, but the N is replaced by ∞:
PV=CF∞∑
t=1(1
1+i)t
As the number of discounting periods approaches inﬁnity, the summa-
tion approaches 1/ i,s o :
PV=CF
i(10.10)
Suppose you are considering an investment that promises to pay $100
each period forever, and the interest rate you can earn on alternative invest-

ments of similar risk is 5% per period. What are you willing to pay today
for this investment?
PV=$100
0.05=$2,000
Therefore, you would be willing to pay $2,000 today for this investment
to receive, in return, the promise of $100 each period forever.
EXAMPLE 10.8: PERPETUITY
Suppose that you are given the opportunity to purchase an investment
for $5,000 that promises to pay $50 at the end of every period forever.
What is the periodic interest per period—the return—associated with

this investment?
Solution
We know that the present value is PV=$5,000 and the periodic,
perpetual payment is CF=$50. Inserting these values into the formula
for the present value of a perpetuity,
$5,000 =$50
i
Solving for i,C F=$50, i=0.01 or 1%. Therefore, an investment
of $5,000 that generates $50 per period provides 1% compounded
interest per period.

The Math of Finance 227
Valuing an Annuity Due
In the ordinary annuity cash ﬂow analysis, we assume that cash ﬂows occur
at the end of each period. However, there is another fairly common cash
ﬂow pattern in which level cash ﬂows occur at regular intervals, but the

ﬁrst cash ﬂow occurs immediately. This pattern of cash ﬂows is called anannuity due. For example, if you win the Mega Millions grand prize, you
will receive your winnings in 20 installments (after taxes, of course). The
20 installments are paid out annually, beginning immediately. The lotterywinnings are therefore an annuity due.
Like the cash ﬂows we have considered thus far, the future value of
an annuity due can be determined by calculating the future value of each

cash ﬂow and summing them. And, the present value of an annuity due
is determined in the same way as a present value of any stream of cashﬂows.
Let’s consider ﬁrst an example of the future value of an annuity due,
comparing the values of an ordinary annuity and an annuity due, eachcomprising four cash ﬂows of $500, compounded at the interest rate of 4%
per period. We show the calculation of the future value of both the ordinary

annuity and the annuity due at the end of three periods in Exhibit 10.8. Youwill notice that the future value of the annuity due is 1 +imultiplied by the
future value of the ordinary annuity. This is because each cash ﬂow earnsinterest for one more periods in the case of the annuity due.
The present value of the annuity due is calculated in a similar manner,

adjusting the ordinary annuity formula for the different number of discountperiods. Because the cash ﬂows in the annuity due situation are each dis-counted one less period than the corresponding cash ﬂows in the ordinary
annuity, the present value of the annuity due is greater than the present value
of the ordinary annuity for an equivalent amount and number of cash ﬂows.
We show this in Exhibit 10.9 for the same four-payment, $500 annuity, but

this time we compare the present value of the ordinary annuity with thepresent value of the annuity due.
You will notice that there is one more period of discounting for each cash
ﬂow in the ordinary annuity, as compared to the annuity due. Therefore,the present value of the annuity due is equal to the present value of the
ordinary annuity multiplied by 1 +i; that is, $1,814.95 (1 +0.04) =
$1,887.55.
Calculating the value of an annuity due using a calculator or a spread-

sheet is similar to that of the ordinary annuity, but with one small differ-
ence. With calculators, you need to change the mode to the “due” or “begin”mode. For example, when calculating the present value of the four-payment,
$500 annuity with the HP10B calculator,

228 VALUATION AND ANALYTICAL TOOLS
EXHIBIT 10.9 Time Line for a Series of Even Cash Flows Deposited to Earn
A: Present Value of the Ordinary Annuity
01 2 3 4
| ||||
||||
$480.77 /arrowdwnleft1
462.28 /arrowdwnleft1
444.50 /arrowdwnleft1
427.40 /arrowdwnleft1
$1,814.95
B: Present Value of the Annuity Due
01 2 3 4
| ||||
||||

01 2 3 4
| ||||
||||
480.77 /arrowdwnleft1
$1,887.55
Ordinary Annuity Annuity Due
PMT =500
i=4
N=4
END modePMT =500
i=4
N=4
BEG mode
Using spreadsheets, the only difference is the last argument in the func-
tion (0 or nothing for an ordinary annuity, 1 for an annuity due):
=PV(0.04,4,500,0,0) =PV(0.04,4,500,0,1)

The Math of Finance 229
Valuing a Deferred Annuity
Adeferred annuity has a stream of cash ﬂows of equal amounts at regular
periods starting at some time after the end of the ﬁrst period. When we
calculated the present value of an annuity, we brought a series of cash ﬂows

back to the beginning of the ﬁrst period—or, equivalently the end of theperiod 0. With a deferred annuity, we determine the present value of the
ordinary annuity and then discount this present value to an earlier period.
Suppose you want to deposit an amount today in an account such that
you can withdraw $100 per year for three years, with the ﬁrst withdrawaloccurring three years from today. We diagram this set of cash ﬂows in Panel
A of Exhibit 10.9.
We can solve this problem in two steps:

Step 1: Solve for the present value of the withdrawals.
Step 2: Discount this present value to the present.
The ﬁrst step requires determining the present value of a three-cash-ﬂow
ordinary annuity of $100. This calculation provides the present value as of
the end of the second year (one period prior to the ﬁrst withdrawal), using

an ordinary annuity. Based on this calculation (present value of an ordinaryannuity, N=3,i=5%,P M T =$100), you need $272.32 in the account at
the end of the second period in order to satisfy the three withdrawals. Weshow this in Panel B of Exhibit 10.9.
2
The next step is to determine how much you need to deposit today to
meet the savings goal of $272.32 at the end of the second year. The $272.32is the future value, N=2, and i=5%. Therefore, you need to deposit

$247.01 today so that you will have $272.32 in two years, so that you canthen begin to make withdrawals starting at the end of the third year. Weshow this in Panel C of Exhibit 10.9.
We can check our work by looking at the balance in the account at
the end of each period, as we show in Panel D of Exhibit 10.9. If wehave performed the calculations correctly, we should end up with a zero
balance at the time of the last $100 withdrawal. Remember, the funds left in

the account earn 5%. Therefore, for example, in the third period, you beginwith $272.33 in the account. The account balance earns 5% or $13.62 of
interest during the third year. This brings the balance in the account to
2We could have also solved this problem using an annuity due in the ﬁrst step, which
would mean that we would discount the value from the ﬁrst step three periods instead
of two.

230 VALUATION AND ANALYTICAL TOOLS
$272.33 +13.62 =$285.95. Once we remove the $100, the balance at the
end of the third year is $185.95.
EXAMPLE 10.9: DEFERRED ANNUITY
Suppose you want to retire and be able to withdraw $40,000 per year
each year for twenty years after your retirement. If you plan to stop
deposits in your retirement account ten years prior to retirement, what

is the balance that you must have in your retirement account ten yearsbefore you retire if you can earn 4% per year on your retirement
investments?
Solution
Balance in the account one year before retirement is the present value
of an ordinary annuity with:
PMT =$40,000
N=20
i=4%
Solve for PV.PV
one year before retirement =$543,613.05
Balance needed ten years before retirement:
PV10 years before retirement =PVone year before retirement ÷(1+0.04)9
=$381,935.32

Deferred annuity problems can become more complex, such as deter-
mining a set of payments needed for some future goal. However, all de-
ferred annuity problems can be solved easily by breaking down the problem
into steps.3
LOAN AMORTIZATION
If an amount is loaned and then repaid in installments, we say that the
loan is amortized. Therefore, loan amortization is the process of calculating
3Unfortunately, there are no calculator functions or spreadsheet functions that per-

form deferred annuity calculations speciﬁcally, because there are so many variations
possible on how these are designed.

The Math of Finance 231
the loan payments that amortize the loaned amount. We can determine the
amount of the loan payments once we know the frequency of payments, theinterest rate, and the number of payments.
Consider a loan of $100,000. If the loan is repaid in four annual install-

ments (at the end of each year) and the interest rate is 6% per year. The ﬁrstthing we need to do is to calculate the amount of each payment. In other
words, we need to solve for CF:
$100,000=
4∑
t=1CF
(1+0.06)t
We want to solve for the loan payment, that is, the amount of the
annuity. The calculator and spreadsheet inputs for this calculation are:
PV=100,000
i=6%
N=4
and then solve for PMT . This is the CF, the loan payment.
The loan payment is $28,859.15. We can calculate the amount of inter-

est and principal repayment associated with each loan payment using a loan
amortization schedule, as we show in Panel A of Exhibit 10.10.
The loan payments are determined such that after the last payment is
made there is no loan balance outstanding. Thus, the loan is referred to asafully amortizing loan . You can see this in Panel B of Exhibit 10.3. Even
though the loan payment each year is the same, the proportion of interest

and principal differs with each payment: the interest is 5% of the principal
amount of the loan that remains at the beginning of the period, whereas the
principal repaid with each payment is the difference between the payment
and the interest. As the payments are made, the remainder is applied torepayment of the principal. This is the scheduled principal repayment or the
amortization. As the principal remaining on the loan declines, less interest
is paid with each payment.

Loan amortization works the same whether this is a mortgage loan to
purchase a home, a term loan, or any other loan such as an automobile loanin which the interest paid is determined on the basis of the remaining amountof the loan. You can modify the calculation of the loan amortization to
suit different principal repayments, such as additional lump-sum payments,
known as balloon payments. See Exhibit 10.11.

232 VALUATION AND ANALYTICAL TOOLS
A. The savings problem
012345
||||||
||||||
? $100 $100 $100
B. Determining goal at the beginning of the payments
012345
||||||
||||||
$95.24
90.70
86.38
$272.32
C. Determining the deposit that meets goal
012345
||||||||||||
$272.32
$247.01
D. Checking the calculations
$300
$0

$247.01
$300
$0
Period$0.00$272.33$259.36$247.01Balance in the Account$95.24$185.95
0 1 234 5$50$100$150$200$250
EXHIBIT 10.10 Deferred Annuity Time Lines for a Three-Period,
$100 Annuity with the First Cash Flow Deferred Three Periods
INTEREST RATES AND YIELDS
Calculating the present or future value of a lump-sum or set of cash ﬂows
requires information on the timing of cash ﬂows and the compound or

discount rate. However, there are many applications in which we are pre-
sented with values and cash ﬂows, and wish to calculate the yield or implied

The Math of Finance 233
YearBeginning
balance of
the loan
outstanding PaymentInterest
= 6%  ×
beginning
balance of
the loanPrincipal
repaid with
payment
= payment –
interestRemaining
principal
= beginning
balance –
principal
repaid
1 $100,000.00 $28,859.15 $6,000.00 $22,859.15 $77,140.85
2 $77,140.85 $28,859.15 $4,628.45 $24,230.70 $52,910.15

3 $52,910.15 $28,859.15 $3,174.61 $25,684.54 $27,225.61
4 $27,225.61
$100,000$100,000.00
$00Loan Balance Remaining
12
Year34$20,000$40,000$60,000$80,000$28,859.15 $1,633.54 $27,225.61 $0.00A. Amortization of the loan
B. Payoff of loan
$77,140.85
$52,910.15
$27,225.61
$0.0
EXHIBIT 10.11 Loan Amortization of a Four-Year $100,000 Loan, with an
Interest Rate of 6%
interest rate associated with these values and cash ﬂows. By calculating the

yield or implied interest rate, we can then compare investment or ﬁnancingopportunities.
Annual Percentage Rate vs. Effective Annual Rate
A common problem in ﬁnance is comparing alternative ﬁnancing or invest-ment opportunities when the interest rates are speciﬁed in a way that makesit difﬁcult to compare terms. The Truth in Savings Act of 1991 requires
institutions to provide the annual percentage yield for savings accounts. As

a result of this law, consumers can compare the yields on different savings

234 VALUATION AND ANALYTICAL TOOLS
arrangements. But this law does not apply beyond savings accounts. One
investment may pay 10% interest compounded semiannually, whereas an-other investment may pay 9% interest compounded daily. One ﬁnancing
arrangement may require interest compounding quarterly, whereas another
may require interest compounding monthly.

Want to compare investments or ﬁnancing with different frequencies of
compounding? We must ﬁrst translate the stated interest rates into a commonbasis. There are two ways to convert interest rates stated over different timeintervals so that they have a common basis: the annual percentage rate and
the effective annual interest rate.
One obvious way to represent rates stated in various time intervals on a

common basis is to express them in the same unit of time—so we annualizethem. The annualized rate is the product of the stated rate of interest per
compound period and the number of compounding periods in a year. Let
ibe the rate of interest per period and nbe the number of compounding
periods in a year. The annualized rate, which is as we indicated earlier in this
chapter also referred to as the nominal interest rate or the annual percentage
rate (APR), is
APR=i×n (10.11)

Another way of converting stated interest rates to a common basis is
the effective rate of interest. The effective annual rate (EAR) is the true
economic return for a given time period because it takes into account thecompounding of interest. We also refer to this rate as the effective rate of
interest . The formula is
EAR=(1+i)n−1 (10.12)
Let’s look how the EAR is affected by the compounding. Suppose that

the Safe Savings and Loan promises to pay 2% interest on accounts, com-
pounded annually. Because interest is paid once, at the end of the year, theeffective annual return, EAR, is 2%. If the 2% interest is paid on a semi-
annual basis—1% every six months—the effective annual return is largerthan 2% since interest is earned on the 1% interest earned at the end of theﬁrst six months. In this case, to calculate the EAR, the interest rate per com-

pounding period—six months—is 0.01 (that is, 0.02 ÷2) and the number
of compounding periods in an annual period is 2:
EAR=(1+0.01)
2−1=1.0201 −1=0.0201 or 2.01%
In the case of continuous compounding, the EAR is simply:
EAR continuous compounding =eAPR−1 (10.13)

The Math of Finance 235
Extending this example to the case of quarterly compounding and con-
tinuous compounding with a nominal interest rate of 2%, we ﬁrst calculate
the interest rate per period, i, and the number of compounding periods in a
year, n:
Frequency of
Compounding CalculationEffectiveAnnual Rate
Annual (1+0.02)1−1 2.00%
Semiannual (1 +0.01)2−1 2.01%

Quarterly (1 +0.005)4−1 2.02%
Continuous e0.02−1 2.02%
Figuring out the effective annual rate is useful when comparing inter-
est rates for different investments. It doesn’t make sense to compare theAPRs for different investments having a different frequency of compound-
ing within a year. But since many investments have returns stated in termsof APRs, we need to understand how to work with them.

To illustrate how to calculate effective annual rates, consider the rates
offered by two banks, Bank A and Bank B. Bank A offers 4.2% compoundedsemiannually and Bank B other offers 4.158% compounded continuously.
We can compare these rates using the EARs. Which bank offers the highest
interest rate? The effective annual rate for Bank A is (1 +0.021)
2−1=
4.2441%. The effective annual rate for Bank B is e0.04158–1= 4.2457%.
Therefore, Bank B offers a slightly higher interest rate.

Yields on Investments
Suppose an investment opportunity requires an investor to put up $10,000
million and offers cash inﬂows of $4,000 after one year and $7,000 after
two years. The return on this investment, or yield, is the interest rate that
equates the present values of the $4,000 and $7,000 cash inﬂows to equal
the present value of the $1 million cash outﬂow. This yield is also referred
to as the internal rate of return (IRR) and is calculated as the rate that solves
the following:

$10,000 =$4,000
(1+IRR)1+$7,000
(1+IRR)2
Unfortunately, there is no direct mathematical solution (that is, closed-
form solution) for the IRR, but rather we must use an iterative procedure.
Fortunately, ﬁnancial calculators and ﬁnancial software ease our burden

236 VALUATION AND ANALYTICAL TOOLS
in this calculation. The IRR that solves this equation is 6.023%. In other
words, if you invest $10,000 today and receive $4,000 in one year and
$7,000 in two years, the return on your investment is 6.023%.
Another way of looking at this same yield is to consider that an invest-
ment’s IRR is the interest rate that makes the present value of all expected

future cash ﬂows—both the cash outﬂows for the investment and the subse-
quent inﬂows—equal to zero. We can represent the IRR as the rate that solves
$0=N∑
t=0CFt
(1+IRR)t
We can use a calculator or a spreadsheet to solve for IRR.T od ot h i s ,
however, we must enter the series of cash ﬂows in a manner that can be usedwith the appropriate function. Consider the problem with the present value

of $10,000 and cash ﬂows of $4,000 and $7,000. The ﬁnancial routinesrequire that the cash ﬂows be entered in chronological order, and then the
IRR function be used with these cash ﬂows.
4
Hewlett-Packard10BTexas Instruments
Microsoft Excel 83/84
10000 +/−CFj
4000 CFj7000 CFj
IRR{4000,7000}
STO L1
IRR(− 10000,L1)12
3
4A
−10000
4000
7000
=IRR(A1:A3)
EXAMPLE 10.10: CALCULATING A YIELD
Suppose an investment of $1 million produces no cash ﬂow in the

ﬁrst year but cash ﬂows of $200,000, $300,000, and $900,000 two,
three, and four years from now, respectively. What is the return on thisinvestment?
4If there is no cash ﬂow for a given period, both the calculators and the spreadsheets
require you to enter a zero in place of that cash ﬂow; failing to do so will result in
an incorrect IRR.

The Math of Finance 237
Solution
TheIRR for this investment is the interest rate that solves:
$1,000,000=$200, 000
(1+IRR)2+$300, 000
(1+IRR)3+$900, 000
(1+IRR)4
The return is 10.172%.
We can use this approach to calculate the yield on any type of invest-
ment, as long as we know the cash ﬂows—both positive and negative—and

the timing of these ﬂows. Consider the case of the yield to maturity on
a bond. Most bonds pay interest semiannually—that is, every six months.
Therefore, when calculating the yield on a bond, we must consider the timing
of the cash ﬂows to be such that the discount period is six months.
TRY IT! THE YIELD ON AN INVESTMENT
Suppose you invest $1,000 today in an investment that promises you$1,000 in two years and $10,000 in three years. What is the IRR on

EXAMPLE 10.11: CALCULATING THE YIELD
ON A BOND
Consider a bond that has a current price of 90; that is, if the par value
of the bond is $1,000, the bond’s price is 90% of $1,000 or $900. Andsuppose that this bond has ﬁve years remaining to maturity and an 8%
coupon rate. With ﬁve years remaining to maturity, the bond has 10
six-month periods remaining.
(continued )

238 VALUATION AND ANALYTICAL TOOLS
(Continued)
Solution
With a coupon rate of 8%, this means that the cash ﬂows for interest
is $40 every six months. For a given bond, we therefore have the
following information:
Present value =$900
Number of periods to maturity =10
Cash ﬂow every six months =$40
Additional cash ﬂow at maturity =$1,000

The six-month yield, rd, is the discount rate that solves:
$900 =[10∑
t=1$40
(1+rd)t]
+$1,000
(1+rd)10
Using a calculator or spreadsheet, we calculate the six-month yield
as 5.315% [PV =$900; N =’10; PMT =$40; FV =$1,000]. Bond
yields are generally stated on the basis of an annualized yield, referred
to as the yield to maturity on a bond-equivalent basis. This measure is
analogous to the APR with semiannual compounding. Therefore, yield

to maturity is 10.63%.
■The time value of money is one of the foundation concepts and tools in
ﬁnancial and investment management.
■Using compound interest, we can estimate a value of in the future;
using discounting, we can translate a future value into a value today—a
present value.
■It is important to consider the type of interest—compounding vs.
simple—and the frequency of compounding in determining a present
value of a future value.

■The time value of money mathematics can be used to determine the
present value or future value of a lump-sum amount or of a series of
cash ﬂows, the growth rate of values, the number of periods of interest
to meet a goal, or to simply amortize a loan.

The Math of Finance 239
■Given the cost of an investment and its cash ﬂows, we can calculate the
yield or implied interest rate. By calculating the yield or implied interestrate, we can then compare investment or ﬁnancing opportunities. The
yield or internal rate of return on an investment is the interest rate at
which the present value of the cash ﬂows equals the initial investmentoutlay.

Future Value
a.FV=$100 (1 +0.02)5=$110.41
b.FV=$100 (1 +0.02)10=$121.90
c.FV=$100 (1 +0.02)20=$148.59
Growth Rates
PV=$2,000; FV=$4,000; N=5 Solve for i.i=14.87%
More Growth Rates
Present Value Future Value Number of Periods Growth Rate
$1 $3 6 20.094%
$1000 $2000 9 8.006%
$500 $600 7 2.639%
$1 $1.50 4 10.668%
Frequency of Compounding
a.$100 (1 +0.02)10=$121.899
b.$100 (1 +0.005)40=$122.079
c.$100 e0.2=$122.140
Present Value
PV=$1,000 ÷(1+0.06)10 =$558.39

The Yield on an Investment
Cash ﬂows are −$10,000, $0, $1,000 and $10,000. The yield is 3.332%

240 VALUATION AND ANALYTICAL TOOLS
QUESTIONS
1.What is the relationship between compounding and discounting of a
lump-sum?
2.Complete the following: “The larger the interest rate, the
(larger/smaller) the future value of a value today.”
3.Holding everything else the same, what is the effect of using a higher
discount rate to discount a future value to the present?

4.If you invest the same amount in each of three accounts today, which
account produces the highest future value if the annual percentage rate
is the same? Account A: annual compounding, Account B: quarterly
compounding, Account C: continuous compounding.
5.What distinguishes an ordinary annuity from an annuity due?
6.What distinguishes an ordinary annuity from a deferred annuity?
7.If a cash ﬂow is the same amount each period, ad inﬁnitum, how do we

value the present value of this series of cash ﬂows?
8.Which is most appropriate to use in describing the annual growth ofthe value of an investment: the arithmetic average growth rate or the
geometric average growth rate? Why?
9.How can we break down the valuation of a deferred annuity into man-
ageable parts for computation purposes?
10.Which has the highest present value if the payments and number ofpayments are identical, an ordinary annuity or an annuity due?

11.If you are offered two investments, one that pays 5% simple interest per
year and one that pays 5% compound interest per year, which would
you choose? Why?
12.Consider a borrowing arrangement in which the annual percentage rate
(APR) is 8%.
a.Under what conditions does the effective annual rate of interest
(EAR) differ from the APR of 8%?
b.As the frequency of compounding increases within the annual period,what happens to the relationship between the EAR and the APR?

13.Suppose you deposit $1,000 in an account with an APR of 4%, withcompounding quarterly.
a.After 10 years, what is the balance in the account if you make no
withdrawals?
b.After 10 years, how much interest on interest did you earn?
14.Suppose you are promised $10,000 ﬁve years from today. If the ap-propriate discount rate is 6%, what is this $10,000 worth to you
today?

The Math of Finance 241
15.Suppose you buy a car today and ﬁnance $10,000 of its cost at an APR
of 3%, with payments made monthly.
a.If you ﬁnance the car for 24 months, what is the amount of your
monthly car payment?
b.If you ﬁnance the car for 36 months, what is the amount of your

242

c11 JWBT310-Fabozzi July 1, 2010 14:43 Printer: Courier Westford, Westford, MA
CHAPTER11
Financial Ratio Analysis
A man who keeps all his property in the form of cash and
government bonds has comparatively little to worry or think
about; but on the other hand, he is not using his resources
productively. As the same man proceeds with the development ofsome business enterprise, he puts more and more of his capital into

the various forms of tangible and intangible assets which are
required for the upbuilding of the business. Presently, if he is notcareful, he may ﬁnd himself short of cash and unable to meet his
obligations, although he may be earning good proﬁts.
The same tendency is present everywhere. The executives who
are managing the ﬁnancial affairs of a company cannot assist inmaking the business proﬁtable merely by piling up unnecessary

cash resources. They must be prepared to venture out into themain current of business affairs along with their associates. And as
they venture farther and farther, the danger increases that their
ﬁnancial craft may be swept out of their control. It requiresconstant watchfulness and sound knowledge to steer a middle
course between excessive caution on the one side and rashness in
ﬁnancial management on the other.
—William H. Lough, Business Finance

(New York: The Ronald Press Company, 1919), p. 500
Financial analysis involves the selection, evaluation, and interpretation ofﬁnancial data and other pertinent information to assist in evaluating the
operating performance and ﬁnancial condition of a company. The informa-
tion that is available for analysis includes economic, market, and ﬁnancial
information. But some of the most important ﬁnancial data are provided by

the company in its annual and quarterly ﬁnancial statements.
243

244 VALUATION AND ANALYSIS TOOLS
The operating performance of a company is a measure of how well a
company has used its resources to produce a return on its investment. The
ﬁnancial condition of a company is a measure of its ability to satisfy its
obligations, such as the payment of interest on its debt in a timely manner.

An investor has many tools available in the analysis of ﬁnancial information.These tools include ﬁnancial ratio analysis and cash ﬂow analysis. Cash ﬂows
provide a way of transforming net income based on an accrual system to
a more comparable basis. Additionally, cash ﬂows are essential ingredientsin valuation because the value of a company today is the present value of
its expected future cash ﬂows. Therefore, understanding past and current

cash ﬂows may help in forecasting future cash ﬂows and, hence, determinethe value of the company. Moreover, understanding cash ﬂow allows the
assessment of the ability of a company to maintain current dividends and its
current capital expenditure policy without relying on external ﬁnancing.
In this chapter and the next, we describe and illustrate the basic tools of
ﬁnancial analysis. In this chapter, our focus is on ﬁnancial ratio analysis. Inthe next chapter, we cover cash ﬂow analysis.

CLASSIFYING FINANCIAL RATIOS
A ﬁnancial ratio is a comparison between one bit of ﬁnancial informationand another. Consider the ratio of current assets to current liabilities, which
w er e f e rt oa st h ecurrent ratio. This ratio is a comparison between assets
that can be readily turned into cash—current assets—and the obligations
that are due in the near future—current liabilities. A current ratio of 2, or
2:1, means that we have twice as much in current assets as we need to satisfy

obligations due in the near future.
We can classify ratios according to the way they are constructed and
the ﬁnancial characteristic they are describing. For example, we will see thatthe current ratio is constructed as a coverage ratio (i.e., the ratio of current
assets—available funds—to current liabilities, i.e., the obligation) that we use
to describe a company’s liquidity (its ability to meet its immediate needs).We can also classify ratios according to the dimension of the company’s

performance or condition. For example, a current ratio provides information
on a company’s liquidity, whereas a turnover ratio provides information onthe effectiveness to which the company puts its asset to use.
There are as many different ﬁnancial ratios as there are possible com-
binations of items appearing on the income statement, balance sheet, andstatement of cash ﬂows. We can classify ratios according to the ﬁnancial
characteristic that they capture.

When we assess a company’s operating performance, a concern is
whether the company is applying its assets in an efﬁcient and proﬁtable

Financial Ratio Analysis 245
manner. When an investor assesses a company’s ﬁnancial condition, a con-
cern is whether the company is able to meet its ﬁnancial obligations. Theinvestor can use ﬁnancial ratios to evaluate ﬁve aspects of operating perfor-
mance and ﬁnancial condition:
1.Liquidity
2.Proﬁtability
3.Activity
4.Financial leverage
5.Return on investment

There are several ratios reﬂecting each of the ﬁve aspects of a company’s
operating performance and ﬁnancial condition. We apply these ratios to
the Exemplar Corporation, whose balance sheets, income statements, and
statement of cash ﬂows for two years we show in Exhibits 11.1, 11.2, and
EXHIBIT 11.1
Exemplar Corporation’s Balance Sheets
As of
In MillionsDec. 31,
20X2Dec. 31,
20X1Dec. 31,
20X0
Cash and cash equivalents $110 $105 $100

20X0
Accounts receivable 200 250 175
Inventory 490 510 500
Total current assets $800 $865 $775
Gross property, plant, and equipment 1,200 1,100 1,000
Accumulated depreciation 400 300 200
Net property, plant, and equipment 800 800 $800
Intangible assets 50 50 50
Goodwill 75 75 75
Total assets $1,725 $1,790 $1,700
Accounts payable $100 $90 $100
Current portion of long-term debt 30 25 20
Total current liabilities $130 $115 $120
Long-term debt 163 319 $300

Common stock $20 $20 $20
Paid-in capital in excess of par 100 100 100
Retained earnings 1,332 1,256 1,170
Treasury stock 20 20 10
Shareholders’ equity $1,432 $1,356 $1,280
Total liabilities and equity $1,725 $1,790 $1,700

246 VALUATION AND ANALYSIS TOOLS
EXHIBIT 11.2 Exemplar Corporation’s Income Statements
For the Year Ending
In Millions Dec. 31, 20X2 Dec. 31, 20X1
Revenues $2,000 $1,900
Cost of goods sold 1,600 1,500
Gross proﬁt $400 $400
Selling, general, and administrative expenses 200 180
Earnings before interest and taxes $200 $220
Interest expense 17 16
Earnings before taxes $183 $204
Taxes 73 82

Taxes 73 82
Net income $110 $122
11.3, respectively. We refer to the most recent ﬁscal year for which ﬁnancial
statements are available, FY20X2, as the “current year.” The “prior year”
is the ﬁscal year prior to the current year.
The ratios we introduce here are by no means the only ones that can be
formed using ﬁnancial data, though they are some of the more commonly
EXHIBIT 11.3 Exemplar Corporation’s Statement of Cash Flows

Add: depreciation expense 100 100
Changes in working capital accounts
Accounts receivable 50 −75
Inventory 20 −10
Accounts payable 10 −10
Cash ﬂow for/from operations $290 $127
Capital expenditures −$100 −$100
Sale of property, plant and equipment 0 0
Cash ﬂow for/from investment −$100 −$100
Borrowings $0 $25
Repayments of debt −152 0
Dividends 33 37
Repurchase of stock 0 10
Cash ﬂow for/ from ﬁnancing −$185 −$22

Financial Ratio Analysis 247
used. Further, when we form a ratio using a balance sheet account, such as
inventory, we are simplifying things a bit because in applying these ratiosto evaluate a company’s performance we could more appropriately use an
average of that balance sheet account through the year in some cases, rather

than the year-end value. However, our primary purpose in this chapter is toestablish the basic concepts, deﬁnitions, and calculations in ﬁnancial ratio
analysis before getting too technical.
LIQUIDITY
Liquidity reﬂects the ability of a company to meet its short-term obligations
using those assets that are most readily converted into cash. Assets thatmay be converted into cash in a short period of time are referred to as

liquid assets; they are listed in ﬁnancial statements as current assets. Weoften refer to current assets as working capital , because they represent the
resources needed for the day-to-day operations of the company’s long-termcapital investments. Current assets are used to satisfy short-term obligations,or current liabilities. The amount by which current assets exceed current
liabilities is referred to as the net working capital.
Operating Cycle

How much liquidity a company needs depends on its operating cycle. The
operating cycle is the duration from the time cash is invested in goods and
services to the time that investment produces cash.
What does the operating cycle have to do with liquidity? The longer
the operating cycle, the more current assets are needed (relative to currentliabilities) since it takes longer to convert inventories and receivables into

cash. In other words, the longer the operating cycle, the greater the amount
of net working capital required.
We can estimate the operating cycle for Exemplar Corporation for the
current year using the balance sheet and income statement data. The numberof days Exemplar ties up funds in inventory is determined by the total
amount of money represented in inventory and the average day’s cost of

goods sold. The current investment in inventory—that is, the money “tiedup” in inventory—is the ending balance of inventory on the balance sheet.
Theaverage day’s cost of goods sold is the cost of goods sold on an average
day in the year, which can be estimated by dividing the cost of goods sold
(which is found on the income statement) by the number of days in the year:
Average day’s cost of goods sold =Cost of goods sold
365(11.1)

248 VALUATION AND ANALYSIS TOOLS
Exemplar’s average day’s cost of goods sold for FY20X2 is $1,600 ÷
265=$4.384 million per day.
Exemplar has $490 million of inventory on hand at the end of the year.
How many days’ worth of goods sold is this? One way to look at this

is to imagine that Exemplar stopped buying more raw materials and justﬁnished producing whatever was on hand in inventory, using available raw
materials and work-in-process. How long would it take Exemplar to run
out of inventory?
We compute the days sales in inventory (DSI), also known as the number
of days of inventory , by calculating the ratio of the amount of inventory on
hand (in dollars) to the average day’s cost of goods sold (in dollars per day):

Days sales in inventory (DSI) =Inventory
Average day’s cost of goods sold(11.2)
For Exemplar, the DSI is $490 million ÷$4.384 million =111.78 days.
In other words, Exemplar has approximately 112 days of goods on hand atthe end of the current year. If sales continued at the same price, it wouldtake Exemplar 112 days to run out of inventory.
We can extend the same logic for calculating the number of days between

a sale—when an account receivable is created—and the time it is collectedin cash. If we assume that Exemplar sells all goods on credit, we can ﬁrst
calculate the average credit sales per day and then calculate how many days’
worth of credit sales are represented by the ending balance of receivables.
Theaverage credit sales per day are the ratio of credit sales to the number
of days in a year:
Average credit sales per day =Credit sales
365(11.3)

365(11.3)
If all of its sales are on credit, Exemplar generates $2,000 million ÷
365=$5.479 million of credit sales per day. The days sales outstanding
(DSO), also known as the number of days of credit , in this ending balance
is calculated by taking the ratio of the balance in the accounts receivableaccount to the credit sales per day:
Days sales outstanding (DSO) =Accounts receivable
Average credit sales per day(11.4)
With an ending balance of accounts receivable of $200 million and

assuming all sales are on credit, Exemplar’s DSO for FY20X2 is $200 million÷$5,479 million =36.5 days.

Financial Ratio Analysis 249
If the ending balance of receivables at the end of the year is representative
of the receivables on any day throughout the year, then it takes, on average,
approximately 36.5 days to collect the accounts receivable.
The operating cycle is the sum of the days sales in inventory and the
days sales outstanding:
Operating cycle =DSI+DSO (11.5)

Using what we have determined for the inventory cycle and cash cy-
cle, we see that for Exemplar the operating cycle is 111.78 +36.5=
148.281 days.
We also need to look at the liabilities on the balance sheet to see how
long it takes a company to pay its short-term obligations. We can apply
the same logic to accounts payable as we did to accounts receivable and
inventories. How long does it take a company, on average, to go from

creating a payable (buying on credit) to paying for it in cash?
First, we need to determine the amount of an average day’s purchases
on credit. However, purchases are not identiﬁed on the ﬁnancial state-ments, but instead we must infer this amount from accounts in both the
income statement and the balance sheet. If we assume all the Exemplarpurchases are made on credit and there was no change in the level of in-
ventory, the total purchases for the year would be the cost of goods sold

less any amounts included in cost of goods sold that are not purchases,such as depreciation. Because we do not have a breakdown on the com-
pany’s cost of goods sold showing how much was paid for in cash and how
much was on credit, we will assume that the following relationship holdsfor Exemplar:
Beginning
inventory+Purchases =(Cost of
goods sold−Depreciation)
+Ending
inventory
(11.6)
For Exemplar in FY20X2, we infer purchases of $1,480 million. There-
fore, the purchases per day are

Average purchases per day =Annual purchases
365(11.7)
which for Exemplar are $4.055 million.
Thedays payables outstanding (DPO), also known as the number of
days of purchases , represented in the ending balance in accounts payable is

250 VALUATION AND ANALYSIS TOOLS
calculated as the ratio of the balance in the accounts payable account to the
average day’s purchases:
Days payables outstanding (DPO) =Accounts payable
Average purchases per day(11.8)
For Exemplar in the current year, the DPO is $100 million ÷$4.055
million =24.662 days. This means that on average Exemplar takes approx-

imately 25 days to pay out cash for a purchase.
The operating cycle is how long it takes to convert an investment in cash
back into cash (by way of inventory and accounts receivable). The numberof days of payables tells us how long it takes to pay on purchases madeto create the inventory. If we put these two pieces of information together,
we can see how long, on net, we tie up cash. The difference between the
operating cycle and the number of days of purchases is the cash conversion

cycle (CCC), also known as the net operating cycle :
Cash conversion cycle =DSI+DSO−DPO (11.9)
For Exemplar’s FY20X2,
Cash conversion cycle =11.781 +36.500 −24.662 =123.619 days
The cash conversion cycle is how long it takes for the company to get
cash back from its investments in inventory and accounts receivable, con-sidering that purchases may be made on credit. By not paying for purchasesimmediately (that is, using trade credit), the company reduces its liquidity

needs. Therefore, the longer the net operating cycle, the greater the required
liquidity.
TRY IT! THE OPERATING CYCLE
Complete the following using Exemplar Corporation’s FY20X1 ﬁnan-cial statements:
Days sales outstanding
Days sales in inventory
Days purchases outstanding
Operating cycle
Cash conversion cycle

Financial Ratio Analysis 251
Measures of Liquidity
We can describe a company’s ability to meet its current obligations in several
ways. We can form the current ratio, which is one of the most commonly
used measures of liquidity:
Current ratio =Current assets
Current liabilities(11.10)
The current ratio is an indication of how many times the company can

cover its current liabilities, using its current assets. Exemplar’s current ratio
for FY20X2 is $800 million ÷$130 =6.154 times.
Another liquidity measure is the quick ratio, which is similar to the
current ratio, except we remove the least liquid of the current assets fromthe numerator:
Quick ratio =Current assets −Inventory
Current liabilities(11.11)
The two-for-one ratio of quick assets to current liabilities does not
have to be explained in detail because its use is so general in state-

ment analysis. It is the ﬁrst step toward establishing a student inproportions. Its adoption as a test resulted from the certain knowl-
edge, acquired by bitter experience, that a shrinkage might easily
occur in asset, but rarely in liabilities.
—Robert Morris Associates, Financial Statements,
An Explanation in Brief of a New System for Their
Analysis from the Standpoint of the Credit Grantor
and Business Executive, 1921
By leaving out the least liquid asset, the quick ratio provides a more

conservative view of liquidity. The quick ratio is also known as the acid test
ratio. For Exemplar in the current year, the quick ratio is 2.385 times.
Still another way to measure the company’s ability to satisfy short-term
obligations is the net working capital-to-sales ratio, which compares net
working capital (current assets less current liabilities) with sales:
Net working capital to sales =Net working capital
Revenues(11.12)

This ratio tells us the “cushion” available to meet short-term obligations
relative to sales. Consider two companies with identical working capital of$100,000, but one has sales of $500,000 and the other sales of $1,000,000.

252 VALUATION AND ANALYSIS TOOLS
If they have identical operating cycles, this means that the company with the
greater sales has more funds ﬂowing in and out of its current asset invest-ments (inventories and receivables). The company with more funds ﬂowing
in and out needs a larger cushion to protect itself in case of a disruption in

the cycle, such as a labor strike or unexpected delays in customer payments.The longer the operating cycle, the more of a cushion (i.e., net working
capital) a company needs for a given level of sales.
For Exemplar Corporation, the net working capital to sales ratio for
FY20X2 is
Net working capital to sales =$800 million −130 million
$2,000 million=0.335
The ratio of 0.335 tells us that for every dollar of sales, Exemplar has
33.5 cents of net working capital to support it.

Given the measures of time related to the current accounts—the op-
erating cycle and the cash conversion cycle—and the three measures
of liquidity—current ratio, quick ratio, and net working capital-to-sales
ratio—we know the following about Exemplar Corporation’s ability to meet
its short-term obligations:
■Inventory is less liquid than accounts receivable (comparing days ofinventory with days of credit).

■Current assets are greater than needed to satisfy current liabilities in a
year (from the current ratio).
■The quick ratio tells us that Exemplar can meet its short-term obligations
even without resorting to selling inventory.
■The net working capital “cushion” is 33.5 cents for every dollar of sales(from the net working capital-to-sales ratio.)
Unfortunately, these liquidity ratios don’t provide us with answers to
the following questions:

■How liquid are the accounts receivable? How much of the accounts
receivable will be collectible? Whereas we know it takes, on average,
36.5 days to collect, we do not know how much will never be collected.
■What is the nature of the current liabilities? How much of current
liabilities consists of items that recur (such as accounts payable and
wages payable) each period and how much consists of occasional items(such as income taxes payable)?

■Are there any unrecorded liabilities (such as operating leases) that arenot included in current liabilities?

Financial Ratio Analysis 253
TRY IT! LIQUIDITY RATIOS
Complete the following using Exemplar Corporation’s FY20X1 ﬁnan-
cial statements:
Current ratio
Quick ratio
Net working capital to sales
PROFITABILITY RATIOS
Liquidity ratios indicate a company’s ability to meet its immediate obliga-
tions. Now we extend the analysis by adding proﬁtability ratios, which help

the investor gauge how well a company is managing its expenses. Proﬁt
margin ratios compare components of income with sales. They give the
investor an idea of which factors make up a company’s income and are
usually expressed as a portion of each dollar of sales. For example, the
proﬁt margin ratios we discuss here differ only in the numerator. It is in
the numerator that we can evaluate performance for different aspects of thebusiness.

For example, suppose the investor wants to evaluate how well pro-
duction facilities are managed. The investor would focus on gross proﬁt(revenues less cost of goods sold), a measure of income that is the direct re-
sult of production management. Comparing gross proﬁt with sales produces
thegross proﬁt margin:
Gross proﬁt margin =Gross proﬁt
Revenues(11.13)
This ratio tells us the portion of each dollar of sales that remains after

deducting production expenses. For Exemplar Corporation for the currentyear,
Gross proﬁt margin =$400 million
$2,000 million=20%

254 VALUATION AND ANALYSIS TOOLS
For each dollar of revenues, the company’s gross proﬁt is 35 cents.
Looking at sales and cost of goods sold, we can see that the gross proﬁt
margin is affected by:
■Changes in sales volume, which affect cost of goods sold and sales.
■Changes in sales price, which affect revenues.
■Changes in the cost of production, which affect cost of goods sold.

Any change in gross proﬁt margin from one period to the next is
caused by one or more of those three factors. Similarly, differences in
gross margin ratios among companies are the result of differences in those
factors.
To evaluate operating performance, we need to consider operating ex-
penses in addition to the cost of goods sold. To do this, remove operating

expenses (e.g., selling and general administrative expenses) from gross proﬁt,leaving operating proﬁt, also referred to as earnings before interest and taxes .
Therefore, the operating proﬁt margin is
Operating proﬁt margin =Operating proﬁt
Revenues(11.14)
For Exemplar in the current year, the operating proﬁt margin is 10%.
Therefore, for each dollar of revenues, Exemplar has 10 cents of operating
income. The operating proﬁt margin is affected by the same factors as gross

proﬁt margin, plus operating expenses.
Both the gross proﬁt margin and the operating proﬁt margin reﬂect
a company’s operating performance. But they do not consider how theseoperations have been ﬁnanced. To evaluate both operating and ﬁnancingdecisions, the investor must compare net income (that is, earnings after
deducting interest and taxes) with revenues. The result is the net proﬁt
margin :
Net proﬁt margin =Net proﬁt
Revenues(11.15)

The net proﬁt margin is the net income generated from each dollar of
revenues; it considers ﬁnancing costs that the operating proﬁt margin does
not consider. For Exemplar for the current year, the net proﬁt margin is5.484%. In other words, for every dollar of revenues, Exemplar generates
5.484 cents in net proﬁts.

Financial Ratio Analysis 255
The proﬁtability ratios indicate the following about the operating per-
formance of Exemplar for FY20X2:
■Each dollar of revenues contributes 20 cents to gross proﬁt and 10 cents
to operating proﬁt.
■Every dollar of revenues contributes 5.484 cents to owners’ earnings.

■By comparing the 20 cents operating proﬁt margin with the 5.484 centsnet proﬁt margin, we see that Exemplar has a little more than 14 cents
of ﬁnancing costs for every dollar of revenues.
What these ratios do not indicate about proﬁtability is the sensitivity
of gross, operating, and net proﬁt margins to changes in the sales price and
changes in the volume of sales.
Looking at the proﬁtability ratios for one company for one period gives

the investor very little information that can be used to make judgments
regarding future proﬁtability. Nor do these ratios provide the investor any
information about why current proﬁtability is what it is. We need moreinformation to make these kinds of judgments, particularly regarding the
future proﬁtability of the company. For that, turn to activity ratios, which
are measures of how well assets are being used.
TRY IT! PROFITABILITY RATIOS

Gross proﬁt margin
Operating proﬁt margin
Net proﬁt margin
ACTIVITY RATIOS
We use activity ratios—for the most part, turnover ratios—to evaluate the
beneﬁts produced by speciﬁc assets, such as inventory or accounts receivable,or to evaluate the beneﬁts produced by the totality of the company’s assets.

256 VALUATION AND ANALYSIS TOOLS
Inventory management
Theinventory turnover ratio is a measure of how quickly a company has
used inventory to generate the goods and services that are sold. The inventory
turnover is the ratio of the cost of goods sold to inventory:
Inventory turnover =Cost of goods sold
Inventory(11.16)

For Exemplar for the current year, the inventory turnover is 3.265 times.This ratio indicates that Exemplar turns over its inventory 3.265 times
per year. On average, cash is invested in inventory, goods and services areproduced, and these goods and services are sold 3.265 times a year. Lookingback to the number of days of inventory, we see that this turnover measure
is consistent with the results of that calculation: There are 111.78 calendar

days of inventory on hand at the end of the year; dividing 365 days by111.78 days, we ﬁnd that inventory cycles through (that is, from cash to
sales) 3.265 times a year.
Accounts Receivable Management
In much the same way inventory turnover can be evaluated, an investorcan evaluate a company’s management of its accounts receivable and its
credit policy. The accounts receivable turnover ratio is a measure of how
effectively a company is using credit extended to customers. The reason for

extending credit is to increase sales. The downside to extending credit is the
possibility of default—customers not paying when promised. The beneﬁtobtained from extending credit is referred to as net credit sales—sales on
credit less returns and refunds.
Accounts receivable turnover =Credit sales
Accounts receivable(11.17)
Looking at the Exemplar Corporation income statement, we see an
entry for revenues, but we do not know how much of the amount stated is

on credit. In the case of evaluating a company, an investor would have anestimate of the amount of credit sales. Let us assume that the entire sales
amount represents net credit sales. For Exemplar for the current year, the
accounts receivable turnover is $2,000 million ÷$200 million =10 times.
Therefore, 10 times in the year there is, on average, a cycle that begins with
a sale on credit and ﬁnishes with the receipt of cash for that sale.

Financial Ratio Analysis 257
The number of times accounts receivable cycle through the year is
consistent with the days sales outstanding (36.5 days) that we calculated
earlier—accounts receivable turn over 10 times during the year, and the
average number of days of sales in the accounts receivable balance is
365 days ÷10 times =36.5 days.
Overall Asset Management

The inventory and accounts receivable turnover ratios reﬂect the beneﬁts
obtained from the use of speciﬁc assets (inventory and accounts receivable).
For a more general picture of the productivity of the company, an investorcan compare the sales during a period with the total assets that generated
these revenues.
One way is with the total asset turnover ratio, or simply the asset
turnover , which is how many times during the year the value of a com-

pany’s total assets is generated in revenues:
Total asset turnover =Revenues
Total assets(11.18)
For Exemplar in the current year, the total asset turnover is $2,000
million ÷$1,175 =1.159 times.
The turnover ratio of 1.159 indicated that in the current year, every
dollar invested in total assets generates $1.159 of revenues. Because total
assets include both tangible and intangible assets, this turnover indicateshow efﬁciently all assets were used.

From these ratios the investor can determine that:
■Inventory ﬂows in and out almost 3.3 times a year (from the inventory
turnover ratio).
■Accounts receivable are collected in cash, on average, 36.5 days after
a sale (from the number of days of credit). In other words, accounts
receivable ﬂow in and out almost 10 times during the year (from the
accounts receivable turnover ratio).
But what these ratios do not indicate about the company’s use of its
assets:

assets:
■The sales not made because credit policies are too stringent.
■How much of credit sales is not collectible.
■Which assets contribute most to the total asset turnover.

258 VALUATION AND ANALYSIS TOOLS
TRY IT! ACTIVITY RATIOS
TurnoverNumber
of daysProduct of the turnover
and the number of days
Inventory
Accounts
receivable
FINANCIAL LEVERAGE

Inventory
Accounts
A company can ﬁnance its assets with equity or with debt. Financing withdebt legally obligates the company to pay interest and to repay the principal
as promised. Equity ﬁnancing does not obligate the company to pay anything
because dividends are paid at the discretion of the board of directors. Thereis always some risk, which we refer to as business risk, inherent in any busi-

ness enterprise. But how a company chooses to ﬁnance its operations—theparticular mix of debt and equity—may add ﬁnancial risk on top of busi-ness risk. Financial risk is risk associated with a company’s ability to satisfy
its debt obligations, and is often measured using the extent to which debtﬁnancing is used relative to equity.
We use ﬁnancial leverage ratios to assess how much ﬁnancial risk the

company has taken on. There are two types of ﬁnancial leverage ratios: com-ponent percentages and coverage ratios. Component percentages compare
a company’s debt with either its total capital (debt plus equity) or its equity
capital. Coverage ratios reﬂect a company’s ability to satisfy ﬁxed ﬁnancingobligations, such as interest, principal repayment, or lease payments.
Component Percentage Ratios
A ratio that indicates the proportion of assets ﬁnanced with debt is the debt-

to-assets ratio , which compares total liabilities (Short-term debt +Long-
term debt) with total assets:
Debt to assets =Debt
Total assets(11.19)

Financial Ratio Analysis 259
For Exemplar in the current year, the debt to assets is 16.959%. This
ratio indicates that 16.959% of the company’s assets are ﬁnanced with debt
(both short term and long term).
Another way to look at the ﬁnancial risk is in terms of the use of debt
relative to the use of equity. The debt-to-equity ratio , or simply the debt-

equity ratio, is a measure how the company ﬁnances its operations with debt
relative to the book value of its shareholders’ equity:
Debt to equity =Debt
Shareholders’ equity(11.20)
Shareholders’ equity is the book value, or carrying value, of sharehold-
ers’ equity as reported on the company’s balance sheet. For Exemplar forFY20X2, the debt to equity ratio is ($130 million +163 million) ÷$1,432

million or 0.204. For every one dollar of book value of shareholders’ equity,Exemplar uses 20.4 cents of debt.
Both of these ratios can be stated in terms of total debt, as above, or in
terms of long-term debt or even simply interest-bearing debt. And it is notalways clear in which form—total, long-term debt, or interest-bearing—the
ratio is calculated. Additionally, it is often the case that the current portion

of long-term debt is excluded in the calculation of the long-term versions ofthese debt ratios.
One problem with using a ﬁnancial ratio based on the book value of
equity to analyze ﬁnancial risk is that there is seldom a strong relationshipbetween the book value and market value of a stock. The distortion in values
on the balance sheet is obvious by looking at the book value of equity and
comparing it with the market value of equity. The book value of equityconsists of:

■The proceeds to the company of all the stock issues since it was ﬁrstincorporated, less any stock repurchased by the company.
■The accumulative earnings of the company, less any dividends, since it
was ﬁrst incorporated.
The book value of equity generally does not give a true picture of the
investment of shareholders in the company because:
■Earnings are recorded according to accounting principles, which may
not reﬂect the true economics of transactions.

■Due to inﬂation, the earnings and proceeds from stock issued in the pastdo not reﬂect today’s values.

260 VALUATION AND ANALYSIS TOOLS
In other words, the book value often understates the value of sharehold-
ers’ equity.
The market value of equity, on the other hand, is the value of equity as
perceived by investors. It is what investors are willing to pay. So why bother

with book value? For two reasons: First, if the company is not publiclytraded, it is easier to obtain the book value than the market value of a
company’s securities. Second, many ﬁnancial services report ratios using
book value rather than market value. However, you can easily restate anyof the ratios presented in this chapter that use the book value of equity using
the market value of equity.
Coverage Ratios
The ratios that compare debt to equity or debt to assets indicate the amount

of ﬁnancial leverage, which enables an investor to assess the ﬁnancial con-
dition of a company. Another way of looking at the ﬁnancial condition and
the amount of ﬁnancial leverage used by the company is to see how wellit can handle the ﬁnancial burdens associated with its debt or other ﬁxed
commitments.
One measure of a company’s ability to handle ﬁnancial burdens is the

interest coverage ratio,a l s or e f e r r e dt oa st h etimes interest-covered ratio.This ratio tells us how well the company can cover or meet the interest
payments associated with debt. The ratio compares the funds available topay interest (that is, earnings before interest and taxes) with the interest
expense:
Interest coverage ratio =EBIT
Interest expense(11.21)
The greater the interest coverage ratio, the better able the company is

to pay its interest expense. For Exemplar for the current year, the interest
coverage ratio is $200 million ÷$17 million =11.617 times. An interest
coverage ratio of 11.617 times means that the company’s earnings before
interest and taxes are 11.617 times greater than its interest payments.
The interest coverage ratio provides information about a company’s

ability to cover the interest related to its debt ﬁnancing. However, there areother costs that do not arise from debt but that nevertheless must be consid-
ered in the same way we consider the cost of debt in a company’s ﬁnancialobligations. For example, lease payments are ﬁxed costs incurred in ﬁnanc-
ing operations. Like interest payments, they represent legal obligations. We
could also consider another ﬁxed charge, such as preferred stock dividends,

Financial Ratio Analysis 261
which the company must pay before a company pays any common stock
dividends.1
Up to now, we considered earnings before interest and taxes as funds

available to meet ﬁxed ﬁnancial charges. EBIT includes noncash items suchas depreciation and amortization. If an investor is trying to compare fundsavailable to meet obligations, a better measure of available funds is cash
ﬂow from operations, as reported in the statement of cash ﬂows. A ratio
that considers cash ﬂows from operations as funds available to cover interestpayments is referred to as the cash ﬂow interest coverage ratio:
Cash ﬂow
interest coverage=Cash ﬂow

Cash ﬂow
from operations+Interest +Taxes
Interest(11.22)
We take the amount of cash ﬂow from operations that is in the statement
of cash ﬂows is net of interest and taxes. Therefore, we must add back interestand taxes to cash ﬂow from operations to arrive at the cash ﬂow amountbefore interest and taxes in order to determine the cash ﬂow available to
cover interest payments.
For Exemplar for the current year, the cash ﬂow interest coverage is
Cash ﬂow

Cash ﬂow
interest coverage=$290 million +17 million +73 million
$17 million=22.565
This coverage ratio indicates that, in terms of cash ﬂows, Exemplar has
22.565 times more cash than is needed to pay its interest. This is a betterpicture of interest coverage than the 11.617 times reﬂected by EBIT. Why
the difference? Because cash ﬂow considers not just the accounting income,but noncash items as well. In the case of Exemplar, depreciation is a noncash

charge that reduced EBIT but not cash ﬂow from operations—it is added
back to net income to arrive at cash ﬂow from operations.
These ratios indicate that Exemplar uses its ﬁnancial leverage as fol-
lows:
■Assets are 17% ﬁnanced with debt, measured using book values.
■Long-term debt is approximately 20% of equity.
1When we alter the interest coverage ratio to consider these other ﬁxed obligations,
we alter the numerator as well to restate it to reﬂect the funds available to cover

262 VALUATION AND ANALYSIS TOOLS
These ratios do not indicate:
■What other ﬁxed, legal commitments the company has that we can-
not see by simply looking at the balance sheet (for example, operating
leases).
■What the intentions of management are regarding taking on more debt
as the existing debt matures.
TRY IT! FINANCIAL LEVERAGE RATIOS

Debt to assets
Debt to equity
Interest coverage ratio
Cash ﬂow interest coverage
RETURN ON INVESTMENT
Return-on-investment ratios compare measures of beneﬁts, such as earnings
or net income, with measures of investment. For example, if an investor

wants to evaluate how well the company uses its assets in its operations,he could calculate the return on assets—sometimes called the basic earning
power ratio—as the ratio of earnings before interest and taxes (also knownas operating earnings) to total assets:
Basic earning power =Earnings before interest and taxes
Total assets(11.23)
For Exemplar Corporation, for the current year, the basic earning power
ratio is $110 million ÷$1,725 million =11.594%. This means that for every

dollar invested in assets, Exemplar earned about 11.6 cents in the current
year. This measure deals with earnings from operations; it does not consider
how these operations are ﬁnanced.

Financial Ratio Analysis 263
Another return-on-assets ratio uses net income—operating earnings less
interest and taxes—instead of earnings before interest and taxes. This is the
more commonly used return on assets ratio:
Return on assets =Net income
Total assets(11.24)
For Exemplar in the current year, the return on assets is $110 million ÷
$1,725 million =6.358%.

Thus, without taking into consideration how assets are ﬁnanced, the
return on assets for Exemplar is 11.594%. Taking into consideration how
assets are ﬁnanced, the return on assets is 6.358%. The difference is due to
Exemplar ﬁnancing part of its total assets with debt, incurring interest of$17 million in the current year.
If we look at Exemplar’s liabilities and equities, we see that the assets

are ﬁnanced by both liabilities and equity. Investors may not be interested in
the return the company gets from its total investment (debt plus equity), but
rather shareholders are interested in the return the company can generateon their investment. The return on equity is the ratio of the net income
shareholders receive to their equity in the stock:
Return on equity =Net income
Shareholders’ equity(11.25)
For Exemplar Corporation, there is only one type of shareholder: com-

mon. For the current year, the return on equity is $110 million ÷$1,725
million =7.656%.
THE DUPONT SYSTEM
The returns-on-investment ratios provide a “bottom line” on the perfor-mance of a company, but do not tell us anything about the “why” behindthis performance. For an understanding of the “why,” an investor must dig a
bit deeper into the ﬁnancial statements. A method that is useful in examining
the source of performance is the DuPont system.

TheDuPont system is a method of breaking down return ratios into
their components to determine which areas are responsible for a company’sperformance. To see how it is used, let us take a closer look at the ﬁrstdeﬁnition of the basic earning power in equation (11.23). We can break
down this ratio into its components: proﬁt margin and activity. We do this
by relating both the numerator and the denominator to sales activity. Divide

264 VALUATION AND ANALYSIS TOOLS
both the numerator and the denominator of the basic earning power ratio
by revenues, which produces
Basic earning power =EBIT
Revenues×Revenues
In other words, the earning power of the company is related to prof-
itability (in this case, operating proﬁt or EBIT) and a measure of activity
(Total asset turnover =Revenues/Total assets):

Basic earning power =Operating
proﬁt margin×Total asset
turnover
Therefore, when analyzing a change in the company’s basic earning
power, an investor could look at this breakdown to see the change in its
components: operating proﬁt margin and total asset turnover.
Let’s look at the return on assets of Exemplar for the two years. Its

returns on assets were 20% in the prior year and 18.18% in the currentyear. We can decompose the company’s returns on assets for the two yearsto obtain:
FY20X2: 11.594% =$200
$2,000×$2,000
$1,725=10%×1.1594
FY20X1: 12.291% =$180
$1,090×$1,900
$1,790=11.579% ×1.0615
We see that operating proﬁt margin declined over the two years, yet asset
turnover improved slightly. Therefore, the decline in the return-on-assets isattributable to lower proﬁt margins.

We can break down the return on assets and the return on equity into
components in a similar manner. Expanding equation (11.24),
Total assets=Net proﬁt
margin×Total asset
turnover
Recognizing the accounting relationship between operating proﬁt and
net income, and letting EBT =EBIT – interest, then
Net income
Revenues=EBIT
Revenues×EBT
EBIT×(1−Tax rate )

Financial Ratio Analysis 265
and, therefore,
Return on assets =EBIT
EBIT×(1−Tax rate )×Revenues
In other words, the return on assets is:
■Positively related to the operating proﬁt margin, EBIT/
Revenues.
■Negatively related to the amount of interest, relative to earnings (the
greater the interest, the lower is EBT/
EBIT.
■Negatively related to the tax rate.

EBIT.
■Positively related to the asset turnover.
The breakdown of a return-on-equity ratio from equation (11.25)
requires a bit more decomposition because instead of total assets as the
denominator, the denominator in the return is shareholders’ equity. Because
activity ratios reﬂect the use of all of the assets, not just the proportion ﬁ-
nanced by equity, we need to adjust the activity ratio by the proportion that

assets are ﬁnanced by equity (i.e., the ratio of the book value of shareholders’
equity to total assets):
Total assets×Total assets
Shareholders’ equity
Identifying the ratio of total assets to shareholders’ equity as the equity
multiplier, which captures the company’s ﬁnancial leverage, we can rephrasereturn on equity as
Return on equity =Return on assets ×Equity multiplier
If we substitute the breakdown of the return on assets into this equation

for the return on equity, we have
Return on
equity=[EBIT
Total assets]
×Total assets
Shareholders’
equity
In other words, the return on equity is a function of operating proﬁt,
the company’s interest burden, the tax rate, asset utilization, and ﬁnancial
leverage. Applying this to Exemplar for FY20X2,
Return on equity =0.010 ×0.914 ×(1−0.4)×1.159 ×1.204 =7.656%

266 VALUATION AND ANALYSIS TOOLS
TRY IT! BREAKING DOWN THE RETURN ON EQUITY
Basic earning power ratio
EBT/EBIT
Tax rate
Equity multiplier
COMMON-SIZE ANALYSIS

Tax rate
An investor can evaluate a company’s operating performance and ﬁnancialcondition through ratios that relate various items of information contained
in the ﬁnancial statements. Another way to analyze a company is to look at
its ﬁnancial data more comprehensively.
Common-size analysis is a method of analysis in which the components

of a ﬁnancial statement are compared. In the vertical common-size analysis,each ﬁnancial statement item is compared to a benchmark item for that sameyear. The ﬁrst step in this form of common-size analysis is to break down a
ﬁnancial statement—either the balance sheet or the income statement—into
its parts. The next step is to calculate the proportion that each item represents
relative to some benchmark. In the case of a vertical common size analysis

of the balance sheet, the benchmark is total assets; in the case of the incomestatement, the benchmark is revenues.
Another form of common-size analysis is horizontal common-size
analysis, in which we use either an income statement or a balance sheetin a ﬁscal year and compare accounts to the corresponding items in
another year.
Let us see how it works by doing some common-size ﬁnancial anal-

ysis for the Exemplar Corporation. In the income statement, as with thebalance sheet, the items may be restated as a proportion of sales; this state-
ment is referred to as the common-size income statement. We provide the

Financial Ratio Analysis 267
EXHIBIT 11.4 Exemplar Corporation’s Vertical Common-Size Income Statements
For Year Ending
Dec. 31, 20X2 Dec. 31, 20X1
Revenues 100% 100%
Cost of goods sold 80% 79%
Gross proﬁt 20% 21%
Selling, general, and administrative expenses 10% 9%
Earnings before interest and taxes 10% 12%
Interest expense 1% 1%
Earnings before taxes 9% 11%
Taxes 4% 4%
Net income 5% 6%

Taxes 4% 4%
common-size income statements for Exemplar for the two years in
Exhibit 11.4. For the current year, the major costs are associated with goods
sold (80%). Looking at gross proﬁt, EBIT, and net income, these proportionsare the proﬁt margins we calculated earlier. Using the common-size income
statement, we learn about the proﬁtability of different aspects of the com-

pany’s business. Again, the picture is not yet complete. For a more completepicture, the investor must look at trends over time and make comparisons
with other companies in the same industry.
We restate the company’s balance sheet in Exhibit 11.5. This statement
does not look precisely like the balance sheet we have seen before. Neverthe-less, the data are the same but reorganized. Each item in the original balance

sheet has been restated as a proportion of total assets for that year. Hence,we refer to this as the common-size balance sheet .
In this common-size balance sheet, we see, for example, that in the
current year cash is 6% of total assets. The largest investment is in plant
and equipment, which comprises 46% of total assets. On the liabilities
side, current liabilities are 8% of liabilities and equity. Using the common-size balance sheet, we can see, in very general terms, how Exemplar has

raised capital and where this capital has been invested. As with ﬁnancial
ratios, however, the picture is not complete until trends are examined andcompared with those of other companies in the same industry.
We provide a horizontal common-size analysis for Exemplar’s balance
sheet in Exhibit 11.6. In this analysis, we see that current and total assetshave declined since FY20X1, the company is using less long-term debt, and

equity has increased. If we wanted to look at relative trends, we could carry
this out over 5 or 10 ﬁscal periods.

268 VALUATION AND ANALYSIS TOOLS
EXHIBIT 11.5 Exemplar Corporation’s Vertical Common-Size Balance Sheets
As of
Cash and cash equivalents 6% 6%
Accounts receivable 12% 14%
Inventory 28% 28%
Total current assets 46% 48%
Gross property, plant, and equipment 70% 61%
Accumulated depreciation 23% 17%
Net property, plant, and equipment 46% 45%
Intangible assets 3% 3%

Goodwill 4% 4%
Total assets 100% 100%
Accounts payable 6% 5%
Current portion of long-term debt 2% 1%
Total current liabilities 8% 6%
Long-term debt 9% 18%
Common stock 1% 1%
Paid-in capital in excess of par 6% 6%
Retained earnings 77% 70%
Treasury stock 1% 1%
Shareholders’ equity 83% 76%
Total liabilities and equity 100% 100%
Note: Each account is divided by total assets. For example, FY20X2 inventory of
$490 million, divided by total assets of $1,725, results in 28.41%.

USING FINANCIAL RATIO ANALYSIS
Financial analysis provides information concerning a company’s operating
performance and ﬁnancial condition. This information is useful for an in-vestor in evaluating the performance of the company as a whole, as well
as of divisions, products, and subsidiaries. An investor must also be aware
that ﬁnancial analysis is also used by investors and investors to gauge theﬁnancial performance of the company.

But ﬁnancial ratio analysis cannot tell the whole story and must be
interpreted and used with care. Financial ratios are useful but, as notedin the discussion of each ratio, there is information that the ratios do not
reveal. For example, in calculating inventory turnover we need to assume
that the inventory shown on the balance sheet is representative of inventory

Financial Ratio Analysis 269
EXHIBIT 11.6 Exemplar Corporation’s Horizontal Common-Size Analysis
Balance Sheet (base year is ﬁscal year 20X1 )
Cash and cash equivalents 105% 100%
Accounts receivable 80% 100%
Inventory 96% 100%
Total current assets 92% 100%
Gross property, plant, and equipment 109% 100%
Accumulated depreciation 133% 100%

Net property, plant, and equipment 100% 100%
Intangible assets 100% 100%
Goodwill 100% 100%
Total assets 96% 100%
Accounts payable 111% 100%
Current portion of long-term debt 120% 100%
Total current liabilities 113% 100%
Long-term debt 51% 100%
Common stock 100% 100%
Paid-in capital in excess of par 100% 100%
Retained earnings 106% 100%
Treasury stock 100% 100%
Shareholders’ equity 106% 100%
Total liabilities and equity 96% 100%

Note: Each account in Y20X2 is divided by the account’s value in FY20X1. For
example, the FY20X2 inventory divided by FY20X1 inventory, $490 million ÷510
million, is 96.08%.
throughout the year. Another example is in the calculation of accounts
receivable turnover. We assumed that all sales were on credit. If we are on
the outside looking in—that is, evaluating a company based on its ﬁnancial

statements only, such as the case of a ﬁnancial investor or investor—and,
therefore, do not have data on credit sales, assumptions must be made that
may or may not be correct.
In addition, there are other areas of concern that an investor should be
aware of in using ﬁnancial ratios:
■Limitations in the accounting data used to construct the ratios.
■Selection of an appropriate benchmark company or companies for com-
parison purposes.
■Interpretation of the ratios.

270 VALUATION AND ANALYSIS TOOLS
■Pitfalls in forecasting future operating performance and ﬁnancial con-
dition based on past trends.
■Financial ratios are useful in evaluating the operating performance and
ﬁnancial condition of a company. With ratios, we can examine a com-
pany’s liquidity, proﬁtability, and efﬁciency in putting its assets to use,

as well as its ability to meet it debt obligations.
■Liquidity reﬂects the ability of a company to meet its short-term obliga-
tions using those assets that are most readily converted into cash. Two
of the most commonly used liquidity ratios are the current ratio and the
quick ratio.
■Proﬁtability ratios help investors gauge how well a company is managing
its expenses. Proﬁt margin ratios compare components of income with
sales.

sales.
■Activity ratios help investors and analysts evaluate the beneﬁts produced
by speciﬁc assets, such as inventory or accounts receivable, or evaluate
the beneﬁts produced by the totality of the company’s assets. For themost part, activity ratios are turnover ratios.
■Financial leverage ratios aid investors and analysts in assessing the ex-posure of the company to ﬁnancial risk. There are two types of ﬁnancialleverage ratios: component percentages and coverage ratios.

■Return-on-investment ratios provide investors and analysts with a wayto compare measures of beneﬁts, such as earnings or net income, with
measures of investment.
■We can break down overall performance measures, such as the return
on assets, into components using the DuPont system. This breakdown
is useful in examining the drivers to changes in returns.
■We can use common-size analysis to examine relative changes in ac-
counts over time, either using horizontal analysis or vertical analysis.

The Operating Cycle
Days sales outstanding 124.1
Days sales in inventory 48.026
Days purchases outstanding 23.298Operating cycle 172.126
Cash conversion cycle 148.828

Financial Ratio Analysis 271
Liquidity Ratios
Current ratio 7.522
Quick ratio 3.087
Net working capital to sales 0.395
Proﬁtability Ratios
Gross proﬁt margin 21.053%
Operating proﬁt margin 11.579%
Net proﬁt margin 6.442%
Activity Ratios
of DaysProduct of the
Turnover and the
Number of Days
Inventory 2.941 124.100 365Accounts
receivable7.600 48.036 365

Financial Leverage Ratios
Debt to assets 24.264%
Debt to equity 0.320
Interest coverage ratio 13.75Cash ﬂow interest coverage 8.963
Breaking Down the Return on Equity
Return on equity 9.029%
Basic earning power ratio 12.291%
EBT/EBIT 0.927
Tax rate 40%
Equity multiplier 1.320
QUESTIONS
1.What is the relation between a company’s current ratio and its quickratio?

2.What is the relation between the cash conversion cycle and a company’sneed for liquidity?

272 VALUATION AND ANALYSIS TOOLS
3.Can a company’s cash conversion cycle ever be negative? Explain.
4.What is the relation between a company’s inventory turnover and the
number of days’ inventory?
5.If a company has a return on assets of 10% and a net proﬁt margin of5%, what is the company’s total asset turnover?
6.If a company has a debt-to-assets ratio of 35%, what is the company’s

debt-to-equity ratio?
7.If a company’s use of debt ﬁnancing increases, as compared to equity
ﬁnancing, what would you expect to ﬁnd in terms of a change in return
on equity if the company’s return on assets remains the same?
8.If a company has no debt in its balance sheet, what is the relation
between the return on assets and the return on equity?
9.When would you want to use the basic earning power to comparecompanies instead of the return on assets?

10.If a company has a return on assets of 10% and has a debt-to-assetsratio of 50%, what is the company’s return on equity?
11.Suppose you calculate the following ratios for two companies, A
and B.
Company A Company B
Current ratio 2.0 2.0
Quick ratio 1.0 1.5
What can you say about the relative investment in inventory?
12.Suppose you are comparing two companies that are in the same line of
business. Company C has an operating cycle of 40 days, and Company D

has an operating cycle of 60 days. Company C has a current ratio of 3,
and Company D has a current ratio of 2.5. Comment on the liquidityof the two companies. Which company has more risk of not satisfying
its near-term obligations? Why?
13.Suppose you calculate a return on ﬁxed assets of 20% for 2008
and 15% for 2009 for a company. Explain how you would use the
DuPont system to further investigate this change in the return on ﬁxed
assets.

assets.
14.In examining the trend of returns on assets over a 20-year period for a
company, you ﬁnd that the returns have been declining gradually over
this period. What information would you look at to further explain thistrend?

Financial Ratio Analysis 273
15.Data for the Lubbock Corporation is provided as follows:
Lubbock Corporation
Balance Sheet
As of December 31, 2009 (in millions)
Cash $ 100 Accounts payable $ 300
Marketable securities 300 Other current liabilities 200
Accounts receivable 600 Long-term debt 500
Inventory 1,000 Common stock 2,000
Net plant and equipment 4,000 Retained earnings 3,000

Total assets $6,000 Total liabilities and equity $6,000
Income StatementFor Year Ending December 31, 2009 (in millions)
Sales $12,000
Cost of goods sold* 10,800
Gross proﬁt $1,200
Administration expenses 150
Earnings before interest and taxes $1,050
Interest expense 50
Earnings before taxes $1,000
Taxes 400
Net income $ 600
*Includes depreciation of $800.
Calculate the following ratios for the Lubbock Corporation:a.Current ratio
b.Quick ratio
c.Inventory turnover ratio

d.Total asset turnover ratio
e.Gross proﬁt margin
f.Operating proﬁt margin
g.Net proﬁt margin
h.Debt-to-assets ratio
i.Debt-to-equity ratio
j.Return on assets (basic earning power)
k.Return on equity
16.Consider two companies, each with a return on assets of 10%. Company
X has a return on equity of 15%, and Company Y has a return on equity
of 20%. Which company uses more ﬁnancial leverage? Explain.

274 VALUATION AND ANALYSIS TOOLS
17.Construct the common size balance sheet for Grisham Company for
2009:
Balance Sheet (in millions)
Cash $50 Current liabilities $30
Accounts receivable 30 Long-term debt 90
Inventory 80 Equity 240
Plant and equipment 200
Total assets $360 Total liabilities and equity $360

c12 JWBT310-Fabozzi July 1, 2010 14:55 Printer: Courier Westford, Westford, MA
CHAPTER12
Cash Flow Analysis
Driven by the downturn, CFOs and treasurers are increasingly
switching their companies’ ﬁnancial yardsticks from earnings to
cash. As a result, they’re tracking the ﬂow of cash into and out of
every nook and cranny of their companies’ operations. And thecash-management buzzword of the day is visibility.
—David M. Katz, “The New Cash Managers,”

CFO Magazine, November 23, 2009
One of the key ﬁnancial measures that an investor should understand is thecompany’s cash ﬂow. This is because the cash ﬂow aids in assessing the
ability of the company to satisfy its contractual obligations and maintaincurrent dividends and current capital expenditure policy without relying onexternal ﬁnancing. Moreover, an investor must understand why this measure

is important for external parties, speciﬁcally stock analysts covering the
company. The reason is that the basic valuation principle is that the valueof a company today is the present value of its expected future cash ﬂows. In
this chapter, we discuss cash ﬂow analysis.
DIFFICULTIES WITH MEASURING CASH FLOW
Cash ﬂow is the ﬂow of funds within a company during a period of time. The

primary difﬁculty with measuring a cash ﬂow is that it is a ﬂow: Cash ﬂowsinto the company (i.e., cash inﬂows) and cash ﬂows out of the company
(i.e., cash outﬂows). At any point in time, there is a stock of cash on hand,but the stock of cash on hand varies among companies because of the
size of the company, the cash demands of the business, and a company’s
management of working capital. So what is cash ﬂow? Is it the total amount
275

276 VALUATION AND ANALYSIS TOOLS
of cash ﬂowing into the company during a period? Is it the total amount of
cash ﬂowing out of the company during a period? Is it the net of the cashinﬂows and outﬂows for a period? Well, there is no speciﬁc deﬁnition of cash
ﬂow—and that’s probably why there is so much confusion regarding the

measurement of cash ﬂow. Ideally, a measure of the company’s operatingperformance that is comparable among companies is needed—something
other than net income.
A simple, yet crude method of calculating cash ﬂow requires simply
adding noncash expenses (e.g., depreciation and amortization) to the re-ported net income amount to arrive at cash ﬂow:
Cash ﬂow (Deﬁnition 1) =Net income +Depreciation and amortization
(12.1)
Consider the example of the Exemplar Corporation, whose balance

sheet, income statement, and statement of cash ﬂows we present in Ex-
hibits 12.1, 12.2, and 12.3, respectively. The simplest cash ﬂow estimate,
which we refer to as Deﬁnition 1, is:
Net income $110
Plus Depreciation 100
Equals Cash ﬂow (Deﬁnition 1) $210
This amount is not really a cash ﬂow, but simply earnings before depre-
ciation and amortization. Is this a cash ﬂow that we should use in valuing
a company? Though not a cash ﬂow, this estimated cash ﬂow does allow a

quick comparison of income across companies that may use different depre-
ciation methods and depreciable lives.
The problem with this measure is that it ignores the many other sources
and uses of cash during the period. Consider the sale of goods for credit.This transaction generates sales for the period. Sales and the accompanyingcost of goods sold are reﬂected in the period’s net income and the estimated
cash ﬂow amount. However, until the account receivable is collected, there

is no cash from this transaction. If collection does not occur until the nextperiod, there is a misalignment of the income and cash ﬂow arising from
this transaction. Therefore, the simple estimated cash ﬂow ignores some cash
ﬂows that, for many companies, are signiﬁcant.
Another estimate of cash ﬂow that is simple to calculate is earnings
before interest, taxes, depreciation, and amortization (EBITDA):
Cash ﬂow
(Deﬁnition 2)=Earnings before
interest and taxes+Depreciation

Cash Flow Analysis 277
EXHIBIT 12.1 Exemplar Corporation’s Balance Sheets
As of
20X0

Net property, plant, and equipment $800 $800 $800
Long-term debt 163 319 300
Common stock 20 20 20

For Exemplar’s 20X2 ﬁscal year:
Earnings before interest and taxes $200
PLUS Depreciation and amortization 100
EQUALS Cash ﬂow (Deﬁnition 2): EBITDA $300
However, this measure suffers from the same accrual-accounting bias as
the previous measure, which may result in the omission of signiﬁcant cash
ﬂows. Additionally, EBITDA does not consider interest and taxes, which

may also be substantial cash outﬂows for some companies.
These two rough estimates of cash ﬂows are used in practice not only
for their simplicity, but because they experienced widespread use prior tothe disclosure of more detailed information in the statement of cash ﬂows.

278 VALUATION AND ANALYSIS TOOLS
EXHIBIT 12.2 Exemplar Corporation’s Income Statements
20X1
Taxes 73 82

Taxes 73 82
EXHIBIT 12.3 Exemplar Corporation’s Statements of Cash Flows
20X1
Operations
Changes in working capital accountsAccounts receivable 50 −75
Accounts payable 10
−10
Investments
Sale of property, plant, and equipment 0 0

Financing
Dividends −33 −37
Repurchase of stock 0 −10
Cash ﬂow for/from ﬁnancing −$185 −$23
Change in cash $5 $5

Cash Flow Analysis 279
Currently, the measures of cash ﬂow are wide-ranging, including the simplis-
tic cash ﬂow measures, measures developed from the statement of cash ﬂows,and measures that seek to capture the theoretical concept of free cash ﬂow.
Cash Flows and the Statement of Cash Flows

Prior to the adoption of the statement of cash ﬂows, the information re-garding cash ﬂows was quite limited. The ﬁrst statement that addressed
the issue of cash ﬂows was the statement of ﬁnancial position, which was
required starting in 1971. This statement was quite limited, requiring ananalysis of the sources and uses of funds in a variety of formats. In its earlier
years of adoption, most companies provided this information using what

is referred to as the working capital concept —a presentation of working
capital provided and applied during the period. Over time, many companies
began presenting this information using the cash concept, which is a most
detailed presentation of the cash ﬂows provided by operations, investing,
and ﬁnancing activities.
Consistent with the cash concept format of the funds ﬂow statement, the

statement of cash ﬂows is now a required ﬁnancial statement. The require-ment that companies provide a statement of cash ﬂows applies to ﬁscal years
after 1987.
1This statement requires the company to classify cash ﬂows into
three categories, based on the activity: operating, investing, and ﬁnancing.
Cash ﬂows are summarized by activity and within activity by type (e.g., asset

dispositions are reported separately from asset acquisitions). We have high-lighted the activities in the statement we show in Exhibit 12.3: operations,
investments, and ﬁnancing.
CASH FLOWS FROM AND FOR
The statement of cash ﬂow provides information on three activities:
operations, investments, and ﬁnancing. The cash ﬂows are usually
indicated as “from” if the cash ﬂows are positive for that activity,
and “for” if the cash ﬂow is negative—that is, cash ﬂows out of thecompany.

1Statement of Financial Accounting Standards No. 95, “Statement of Cash Flows.”

280 VALUATION AND ANALYSIS TOOLS
However, in some ﬁnancial statements, the cash ﬂow may simply
be reported as “from,” no matter the sign—positive or negative—the
cash ﬂow. The key is to look at the summed amount for the activity:positive means that funds have ﬂowed to the company and negative
means that funds have ﬂowed from the company.

You may also see variations in the name of the summation. For
example, you may see for operations, “Cash ﬂow from operations” or“Cash ﬂow from operating activities.”
The reporting company may report the cash ﬂows from operating activi-
ties on the statement of cash ﬂows using either the direct method —reporting
all cash inﬂows and outﬂows—or the indirect method—starting with net in-

come and making adjustments for depreciation and other noncash expenses
and for changes in working capital accounts. Though the direct method is
recommended, it is also the most burdensome for the reporting company
to prepare. Most companies report cash ﬂows from operations using the
indirect method. The indirect method has the advantage of providing theﬁnancial statement user with a reconciliation of the company’s net income
with the change in cash. The indirect method produces a cash ﬂow from

operations that is similar to the estimated cash ﬂow measure discussed pre-viously, yet it encompasses the changes in working capital accounts that the
simple measure does not.
The cash ﬂow from operations is our third deﬁnition of cash ﬂow:
Cash ﬂow
(Deﬁnition 3)=Net
income+Depreciation
and amortization−Increase in
working capital(12.3)
From Exhibit 12.3, we see that Exemplar’s cash ﬂow from operations is
$290 million in FY20X2:
P
LUS Depreciation expense 100

P
PLUS Increase in working capital accounts 80
EQUALS Cash ﬂow (Deﬁnition 3) $290
The classiﬁcation of cash ﬂows into the three types of activities pro-
vides useful information that can be used by an analyst to see, for example,

Cash Flow Analysis 281
whether the company is generating sufﬁcient cash ﬂows from operations to
sustain its current rate of growth. However, the classiﬁcation of particu-lar items is not necessarily as useful as it could be. Consider some of the
classiﬁcations:
■Cash ﬂows related to interest expense are classiﬁed in operations, though
they are clearly ﬁnancing cash ﬂows.2

■Income taxes are classiﬁed as operating cash ﬂows, though taxes are
affected by ﬁnancing (e.g., deduction for interest expense paid on debt)
and investment activities (e.g., the reduction of taxes from tax creditson investment activities).
■Interest income and dividends received are classiﬁed as operating cashﬂows, though these ﬂows are a result of investment activities.
Whether these items have a signiﬁcant effect on the analysis depends on

the particular company’s situation. Exemplar, for example, has no interest
and dividend income, and its interest expense of $17 million is not large
relative to its earnings before interest and taxes ($200 million). However,for some companies and some operations, these are signiﬁcant.
Looking at the relation among the three cash ﬂows in the statement
provides a sense of the activities of the company. A young, fast-growing
company may have negative cash ﬂows from operations, yet positive cash

ﬂows from ﬁnancing activities (i.e., operations may be ﬁnanced in large partwith external ﬁnancing). As a company grows, it may rely to a lesser ex-
tent on external ﬁnancing. The typical, mature company generates cash
from operations and reinvests part or all of it back into the company.Therefore, cash ﬂow related to operations is positive (i.e., a source of
cash) and cash ﬂow related to investing activities is negative (i.e., a use

of cash). As a company matures, it may seek less ﬁnancing externallyand may even use cash to reduce its reliance on external ﬁnancing (e.g.,
repay debts).
Another variation in the estimation of cash ﬂow is the discretionary cash
ﬂow.
3Starting with the ﬁrst deﬁnition of cash ﬂow, we adjust for changes in
working capital to arrive at an operating cash ﬂow. From this, we subtract
2The interest expense is deducted from earnings before interest and taxes, and,

therefore, affects the net income and cash ﬂow from operations.
3This is based on the cash ﬂow deﬁnition promoted by Martin Fridson in Financial
Statement Analysis: A Practitioner’s Guide (New York: John Wiley & Son, 1995).
This deﬁnition results from reformatting the statement of cash ﬂows to remove the
nondiscretionary cash ﬂows.

282 VALUATION AND ANALYSIS TOOLS
the capital expenditures to arrive at our fourth deﬁnition of cash ﬂow, the
discretionary cash ﬂow:
Cash ﬂow
(Deﬁnition 4)=Net
working capital−Capital
expenditures
(12.4)
The cash ﬂows related to ﬁnancing are then provided, resulting in a

bottom-line cash ﬂow. By restructuring the statement of cash ﬂows in this
way, it can be seen how much ﬂexibility the company has when it must make
business decisions that may adversely impact the long-run ﬁnancial healthof the enterprise. We show this restated cash ﬂow statement in Exhibit 12.4.
For example, consider a company with a basic cash ﬂow of $800 million

and operating cash ﬂow of $500 million. Suppose that this company paysdividends of $130 million and that its capital expenditure is $300 million.
The discretionary cash ﬂow for this company is $200 million found by
subtracting the $300 million capital expenditure from the operating cash
ﬂow of $500 million. This means that even after maintaining a dividend

payment of $130 million, its cash ﬂow is positive. Notice that asset sales andother investing activity, which are considered “Other investing activities,”
are not needed to generate cash to meet the dividend payments because these
items are subtracted after accounting for the dividend payments. In fact, ifthis company planned to increase its capital expenditures, this breakdown
EXHIBIT 12.4
Reformatted Cash Flow Statement, Highlighting the Exemplar
Corporation’s Financial Flexibility

PLUS Depreciation expense 100 100
Cash ﬂow (Deﬁnition 1) $210 $222
LESS Increase in working capital −80 95
Operating cash ﬂow (Deﬁnition 3) $290 $127
LESS Capital expenditures 100 100
Discretionary cash ﬂow (Deﬁnition 4) $190 $27
LESS Dividends 33 37
LESS Other investing activities 0 0
Cash ﬂow before ﬁnancing $157 −$10
PLUS Borrowings 0 24
LESS Repayments of debt 152 0

LESS Repurchase of stock 0 10
Change in cash $5 $4

Cash Flow Analysis 283
of cash ﬂows into discretionary and nondiscretionary can be used to assess
how much that expansion can be before affecting dividends or increasingﬁnancing needs.
Though we can classify a company based on the sources and uses of

cash ﬂows, more data is needed to put this information in perspective. Whatis the trend in the sources and uses of cash ﬂows? What market, industry,
or company-speciﬁc events affect the company’s cash ﬂows? How does the
company being analyzed compare with other companies in the same industryin terms of the sources and uses of funds?
TRY IT! CALCULATING CASH FLOWS
Calculate the cash ﬂow using each of the four deﬁnitions and Exem-plar’s FY20X1 ﬁnancial information:
Cash ﬂow (Deﬁnition 1)

Cash ﬂow (Deﬁnition 2)
Cash ﬂow (Deﬁnition 3)
Cash ﬂow (Deﬁnition 4)
FREE CASH FLOW
Cash ﬂows without any adjustment may be misleading because they donot reﬂect the cash outﬂows that are necessary for the future existence
of a company. An alternative measure, free cash ﬂow, was developed by
Michael Jensen in his theoretical analysis of agency costs and corporatetakeovers.
4In theory, free cash ﬂow is the cash ﬂow left over after the

company funds all positive net present value projects. Positive net presentvalue projects are those capital investment projects for which the presentvalue of expected future cash ﬂows exceeds the present value of project
outlays, all discounted at the cost of capital.
5In other words, free cash ﬂow
4Michael C. Jensen, “Agency Costs of Free Cash Flow, Corporate Finance, and
Takeovers,” American Economic Review 76 (1985): 323–329.

5Thecost of capital is the cost to the company of funds from creditors and share-
holders. The cost of capital is basically a hurdle: If a project returns more than
its cost of capital, it is a proﬁtable project spent on low-return exploration and

284 VALUATION AND ANALYSIS TOOLS
is the cash ﬂow of the company, less capital expenditures necessary to stay
in business (i.e., replacing facilities as necessary) and grow at the expectedrate (which requires increases in working capital).
The theory of free cash ﬂow was developed by Jensen to explain behav-

iors of companies that could not be explained by existing economic theories.Jensen observed that companies that generate free cash ﬂow should disgorge
that cash rather than invest the funds in less proﬁtable investments. There
are many ways in which companies can disgorge this excess cash ﬂow, in-cluding the payment of cash dividends, the repurchase of stock, and debt
issuance in exchange for stock. The debt-for-stock exchange, for example,

increases the company’s leverage and future debt obligations, obligating thefuture use of excess cash ﬂow. If a company does not disgorge this free cash
ﬂow, there is the possibility that another company—a company whose cash
ﬂows are less than its proﬁtable investment opportunities or a company that
is willing to purchase and lever-up the company—will attempt to acquire
the free-cash-ﬂow-laden company.
As a case in point, Jensen observed that the oil industry illustrates the

case of wasting resources: The free cash ﬂows generated in the 1980s werespent on low-return exploration and development, and on poor diversiﬁca-tion attempts through acquisitions. He argues that these companies would
have been better off paying these excess cash ﬂows to shareholders through
share repurchases or exchanges with debt.
By itself, the fact that a company generates free cash ﬂow is neither good

nor bad. What the company does with this free cash ﬂow is what is impor-tant. And this is where it is important to measure the free cash ﬂow as thatcash ﬂow in excess of proﬁtable investment opportunities. Consider the sim-
ple numerical exercise with the Winner Company and the Loser Company:
Winner Company Loser Company
Cash ﬂow before capital expenditures $1,000 $1,000
Capital expenditures, positive net
present value projects 750 250
Capital expenditures, negative net

present value projects 0 500
Cash ﬂow $250 $250
Free cash ﬂow $250 $750
development and on poor diversiﬁcation attempts through acquisitions. Jensen ar-
gues that these companies would have been better off paying these excess cash ﬂows
to shareholders through share repurchases or exchanges with debt.

Cash Flow Analysis 285
These two companies have identical cash ﬂows and the same total capital
expenditures. However, the Winner Company spends only on projects that
add value (in terms of positive net present value projects), whereas the
Loser Company spends on both proﬁtable projects and wasteful projects.

The Winner Company has a lower free cash ﬂow than the Loser Company,indicating that they are using the generated cash ﬂows in a more proﬁtable
manner. The lesson is that the existence of a high level of free cash ﬂow is
not necessarily good—it may simply suggest that the company is either avery good takeover target or the company has the potential for investing in
unproﬁtable investments. Positive free cash ﬂow may be good or bad news;
likewise, negative free cash ﬂow may be good or bad news:

Free Cash
Flow Good News Bad News
+ Generating substantial
operating cash ﬂows,beyond those necessaryfor proﬁtable projects.Generating more cash ﬂows
than it needs for proﬁtableprojects and may waste thesecash ﬂows on unproﬁtable
projects.
− Has more proﬁtable
projects than it hasoperating cash ﬂows and
must rely on externalﬁnancing to fund these
projects.Unable to generate sufﬁcient
operating cash ﬂows to satisfyits investment needs for future
growth.

growth.
Therefore, once the free cash ﬂow is calculated, other information (e.g.,
trends in proﬁtability) must be considered to evaluate the operating perfor-
mance and ﬁnancial condition of the company.
Calculating Free Cash Flow
There is some confusion when this theoretical concept is applied to actualcompanies. The primary difﬁculty is that the amount of capital expenditures

necessary to maintain the business at its current rate of growth is generallynot known; companies do not report this item and may not even be able
to determine how much of a period’s capital expenditures are attributed to
maintenance and how much are attributed to expansion.
One approach is to estimate free cash ﬂow by assuming that all
capital expenditures are necessary for the maintenance of the currentgrowth of the company. Though there is little justiﬁcation in using all

286 VALUATION AND ANALYSIS TOOLS
expenditures, this is a practical solution to an impractical calculation. This
assumption allows us to estimate free cash ﬂows using published ﬁnancialstatements.
Another issue in the calculation is deﬁning what is truly “free” cash

ﬂow. Generally we think of “free” cash ﬂow as what is left over afterall necessary ﬁnancing expenditures are paid; this means that free cash
ﬂow is after interest on debt is paid. Others calculate free cash ﬂow
before such ﬁnancing expenditures, others calculate free cash ﬂow afterinterest, and still others calculate free cash ﬂow after both interest and
dividends (assuming that dividends are a commitment, though not a legal
commitment).

There is no one correct method of calculating free cash ﬂow and different
analysts may arrive at different estimates of free cash ﬂow for a company.The problem is that it is impossible to measure free cash ﬂow as dictated
by the theory, so many methods have arisen to calculate this cash ﬂow. A
simple method is to start with the cash ﬂow from operations and then deductcapital expenditures:
Free cash ﬂow
(Deﬁnition 1)=Cash ﬂow
from operations−Capital
expendiures(12.5)

This is the same as the discretionary cash ﬂow, our fourth deﬁnition of
cash ﬂow that we discussed previously. For Exemplar in FY20X2:
Cash ﬂow from operations $290
L
ESS Capital expenditures 100
EQUALS Free cash ﬂow (Deﬁnition 1) $190
Another estimate of free cash ﬂow is to adjust the cash ﬂow from op-
erations for the after-tax interest, adding this amount back to arrive at anadjusted cash ﬂow from operations. We make this adjustment because we

want to estimate how much free cash ﬂow is available to both bondholders
and equity owners:
6
(Deﬁnition 2)=Cash ﬂow
from operations−Adjusted
interest−Capital
expenditures(12.6)
6This deﬁnition is similar to still another deﬁnition of free cash ﬂow, net free cash
ﬂow, which adjusts for both interest expenses, but only deducts cash taxes, not
the sum of deferred taxes and cash taxes as represented by the tax expense on acompany’s income statement.

Cash Flow Analysis 287
We often refer to this calculation of free cash ﬂow as the free cash
ﬂow to the ﬁrm (FCFF) because it is the ﬂow available to the suppliers of
capital.
Exemplar’s interest expense is $17 million and its tax rate is 40%.
Making an adjustment for the after-tax interest and ﬁnancing expenses,
$17 million (1 – 0.4) =$10.2 million (which we round to $10 mil-

lion for simplicity in our example), we have another measure of free
cash ﬂow:
PLUS Adjusted interest 10
Adjusted cash ﬂow from operations $300
LESS Capital expenditures 100
EQUALS Free cash ﬂow, FCFF (Deﬁnition 2) $200
Still another free cash ﬂow is a cash ﬂow that adjusts for the net bor-
rowings of the company. The basic idea is that if we want to focus on the

funds available to the owners, we need to consider not only the capitalexpenditures, which reduce cash ﬂow available to owners, but also funds
raised through borrowing, which are available to owners.
(Deﬁnition 3)=Cash ﬂow
expenditures+Borrowings −Debt
repayments
(12.7)
This free cash ﬂow deﬁnition begins with cash ﬂow from operations,
removes capital expenditures, adds new borrowings, and subtracts debt
repayments:

PLUS Borrowings 0
LESS Debt repayments 152
EQUALS Free cash ﬂow, FCFE (Deﬁnition 3) $ 38
Based on this third deﬁnition of free cash ﬂow, Exemplar has free cash
ﬂow available to spend for FY20X2 of $38 million. We refer to this deﬁnitionof free cash ﬂow as the free cash ﬂow to equity, FCFE, because it is the cash
ﬂow available for the company’s owners.

288 VALUATION AND ANALYSIS TOOLS
TRY IT! CALCULATING FREE CASH FLOWS
Calculate the free cash ﬂow using each of the three deﬁnitions and
Exemplar’s FY20X1 ﬁnancial information:
Free cash ﬂow (Deﬁnition 1)
Free cash ﬂow (Deﬁnition 2)
Free cash ﬂow (Deﬁnition 3)
USEFULNESS OF CASH FLOWS ANALYSIS

The usefulness of cash ﬂows for ﬁnancial analysis depends on whether cashﬂows provide unique information or provide information in a manner thatis more accessible or convenient for the analyst. The cash ﬂow information
provided in the statement of cash ﬂows, for example, is not necessarily
unique because most, if not all, of the information is available throughanalysis of the balance sheet and income statement. What the statement does

provide is a classiﬁcation scheme that presents information in a manner that
is easier to use and, perhaps, more illustrative of the company’s ﬁnancialposition.
An analysis of cash ﬂows and the sources of cash ﬂows can reveal the
■The sources of ﬁnancing the company’s capital spending. Does the com-
pany generate internally (i.e., from operations) a portion or all of thefunds needed for its investment activities? If a company cannot generate

cash ﬂow from operations, this may indicate problems up ahead. Re-
liance on external ﬁnancing (e.g., equity or debt issuance) may indicate
a company’s inability to sustain itself over time.
■The company’s dependence on borrowing. Does the company rely heav-
ily on borrowing that may result in difﬁculty in satisfying future debtservice?
■The quality of earnings. Large and growing differences between income
and cash ﬂows suggest a low quality of earnings.

Cash Flow Analysis 289
KRISPY KREME: NOT SO SWEET
Krispy Kreme, a wholesaler and retailer of doughnuts, grew rapidly
after its initial public offering (IPO) in 2000. Income grew as Krispy
Kreme increased the number of retail stores, but the tide in income
turned in the 2004 ﬁscal year and losses continued thereafter:
$100,000
–$100,000
–$200,000
–$300,000
2/1/1998
1/31/1999

–$100,000
–$200,000
–$300,000
2/1/1998
1/31/1999
1/30/20001/28/2001
2/3/20022/2/20032/1/2004
1/30/20051/29/20061/28/2007
2/3/20082/1/2009$0$200,000
Operating incomeIncome, in Thousands
Fiscal Year EndNet income
Krispy Kreme’s growth after its IPO was ﬁnanced by both operat-
ing activities and external ﬁnancing, as evident from its cash ﬂows:
$100,000
$50,000
–$50,000$150,000
–$150,000–$100,000
–$200,000
2/1/1998
1/31/1999

2/3/20082/1/2009$0$200,000Cash flow from operating activities
Cash flow from investing activities
Cash flow from financing activitiesCash Flow, in Thousands
Fiscal Year End

290 VALUATION AND ANALYSIS TOOLS
As you can see, approximately half of the funds to support its rapid
growth came from ﬁnancing, in particular debt ﬁnancing. This resulted
in problems as the company’s debt burden became almost three timesits equity as revenue growth slowed by the 2005 ﬁscal year.
RATIO ANALYSIS

One use of cash ﬂow information is in ratio analysis, primarily with the
balance sheet and income statement information. One such ratio is the cash
ﬂow–based ratio, the cash ﬂow interest coverage ratio, which can be used as ameasure of ﬁnancial risk. There are a number of other cash ﬂow–based ratios
that an analyst may ﬁnd useful in evaluating the operating performance and
ﬁnancial condition of a company.
A useful ratio to help further assess a company’s cash ﬂow is the cash

ﬂow to capital expenditures ratio ,o rcapital expenditures coverage ratio:
Cash ﬂow to capital expenditures =Cash ﬂow
Capital expenditures(12.8)
The cash ﬂow measure in the numerator should be one that has not
already removed capital expenditures; for example, including free cash ﬂowin the numerator would be inappropriate.
This ratio provides information about the ﬁnancial ﬂexibility of the
company and is particularly useful for capital-intensive companies and util-ities.

7The larger the ratio is, the greater the ﬁnancial ﬂexibility. However,
one must carefully examine the reasons why this ratio may be changing over
time and why it might be out of line with comparable companies in the in-
dustry. For example, a declining ratio can be interpreted in two ways. First,the company may eventually have difﬁculty adding to capacity via capital
expenditures without the need to borrow funds. The second interpretation

is that the company may have gone through a period of major capital ex-pansion and therefore it will take time for revenues to be generated that will
increase the cash ﬂow from operations to bring the ratio to some normal
long-run level.
7Fridson, Financial Statement Analysis: A Practitioner’s Guide , 173.

Cash Flow Analysis 291
Another useful cash ﬂow ratio is the cash ﬂow to debt ratio :
Cash ﬂow to debt =Cash ﬂow
Debt(12.9)
where debt can be represented as total debt, long-term debt, or a debt mea-
sure that captures a speciﬁc range of maturity (e.g., debt maturing in ﬁve

years). This ratio gives a measure of a company’s ability to meet matur-ing debt obligations. A more speciﬁc formulation of this ratio is Fitch’s
CFAR ratio, which compares a company’s three-year average net free cash
ﬂow to its maturing debt over the next ﬁve years. By comparing the com-
pany’s average net free cash ﬂow to the expected obligations in the near
term (i.e., ﬁve years), this ratio provides information on the company’s
credit quality.
Using Cash Flow Information

The analysis of cash ﬂows provides information that can be used along withother ﬁnancial data to help assess the ﬁnancial condition of a company.Consider the cash-ﬂow-to-capital-expenditures and the cash-ﬂow-to-debt
ratios calculated using the different measures of cash ﬂow for Exemplar
Corporation for the 20X2 ﬁscal year:
Cash Flow to
Debt RatioCash Flow to
Capital
Expenditures
Cash ﬂow (Deﬁnition 1) 0.717 2.224
Cash ﬂow (Deﬁnition 2) 1.025 3.200

Cash ﬂow (Deﬁnition 3) 0.990 1.274
Cash ﬂow (Deﬁnition 4) 0.648 0.274
Free cash ﬂow (Deﬁnition 1) 0.648 0.274
Free cash ﬂow (Deﬁnition 2) 0.683 0.370
Free cash ﬂow (Deﬁnition 3) 0.129 0.520
The cash ﬂow to capital expenditures ratio ranges from 0.274 to 3.2,
whereas the cash ﬂow to debt ratio ranges from 0.129 to 1.025. As youcan see, it is important to understand the differences among the cash

ﬂow measures, especially when interpreting cash ﬂows and ratios involving
cash ﬂows.

292 VALUATION AND ANALYSIS TOOLS
CASH FLOW MATTERS
James Largay and Clyde Stickney analyzed the ﬁnancial statements of
W. T. Grant during the 1966–1974 period preceding its bankruptcy
in 1975 and ultimate liquidation.8They noted that ﬁnancial indica-
tors such as proﬁtability ratios, turnover ratios, and liquidity ratios
showed some downward trends, but provided no deﬁnite clues to the

company’s impending bankruptcy.
A study of cash ﬂows from operations, however, revealed that the
company’s operations were causing an increasing drain on cash, ratherthan providing cash. This necessitated an increased use of external
ﬁnancing, the required interest payments on which exacerbated thecash ﬂow drain. Cash ﬂow analysis clearly was a valuable tool in this
case since W. T. Grant had been running a negative cash ﬂow from
operations for years.

8James A. Largay and Clyde P. Stickney, “Cash Flows, Ratio Analysis and the
W. T. Grant Company Bankruptcy,” Financial Analysts Journal 36 (1980):
51–54.
■Cash ﬂow analysis is important because a company’s sustainability de-
pends on its ability to generate cash ﬂows. There are alternative measures
of cash ﬂow, including cash ﬂow from operations and free cash ﬂow.

■A company’s free cash ﬂow is the cash ﬂow it generates in excess ofwhat is needed for its capital expenditures.
■We can examine sources and uses of cash ﬂows to gauge a company’s
ability to ﬁnance its own operations. Especially useful in this task is the
cash ﬂows from operating activities, ﬁnancing activities, and investingactivities that a company reports on its statement of cash ﬂows. We can
also use cash ﬂow ﬁnancial ratios to evaluate a company’s performance
and condition.

■Free cash ﬂow is a company’s cash ﬂow that remains after making
capital investments that maintain the company’s current rate of growth.
It is not possible to calculate free cash ﬂow precisely, resulting in manydifferent variations in calculations of this measure.

Cash Flow Analysis 293
Calculating Cash Flows
Cash ﬂow (Deﬁnition 1) $222
Cash ﬂow (Deﬁnition 2) $320
Cash ﬂow (Deﬁnition 3) $127
Cash ﬂow (Deﬁnition 4) $ 27
Calculating Free Cash Flows
Free cash ﬂow (Deﬁnition 1) $27Free cash ﬂow (Deﬁnition 2) $37Free cash ﬂow (Deﬁnition 3) $52
QUESTIONS
1.Why is depreciation added back to net income to arrive at cash ﬂow?

2.Why do we adjust net income for changes in working capital accounts?
3.If a company has cash ﬂow from operations of $3 million, deprecia-tion and amortization of $2 million, and its working capital accounts
did not change from the previous period, what its net income for this
period?
4.How does the statement of cash ﬂows relate to the balance sheet?
5.How does the statement of cash ﬂows relate to the income statement?

6.Is it possible for a company to have a net loss for a period, yet still havea positive cash ﬂow?
7.What distinguishes the free cash ﬂow of a ﬁrm from its cash ﬂow fromoperations?
8.What is the relation between EBITDA and cash ﬂow from operations?
9.How can a negative free cash ﬂow be considered good news?
10.How can a positive free cash ﬂow be considered bad news?

11.Consider the Austin Company, which has a free cash ﬂow to equity of$100 million, and free cash ﬂow to the ﬁrm of $125 million. If the AustinCompany had interest after tax of $10 million, what is the amount of
net borrowing for the Austin Company for this period?
12.Suppose the cash ﬂow from operations of the Knoxville Company is
$200 million and the company had capital expenditures of $50 million
during this period. If Knoxville has no debt in its capital structure, what

294 VALUATION AND ANALYSIS TOOLS
13.Suppose Provo, Inc., had net income of $30 million for the most re-
cent ﬁscal period. If its depreciation and amortization for the period is$3 million and its cash ﬂow from operations is $35 million, what is its
change in working capital for this most recent ﬁscal period?
14.Using the data in this chapter for the Exemplar Company for ﬁscal year

20X2 and the cash ﬂow from operations as the measure of cash ﬂow
(cash ﬂow deﬁnition 3), calculate the:
a.Cash ﬂow to capital expenditures ratio.
b.Cash ﬂow to debt ratio.

c13 JWBT310-Fabozzi July 8, 2010 13:13 Printer: Courier Westford, Westford, MA
CHAPTER13
Capital Budgeting
The general principle is, therefore, that out of the various
income-streams at the disposal of the capitalist, he chooses the
most advantageous, or more fully expressed, the one which,
compared with any other, offers advantages which, reckoned inpresent estimation at the given rate of interest, outweigh the

disadvantages; and this is evidently merely a new formulation of
the original principle that the use chosen will be that which has themaximum present value at the given rate of interest.
—Irving Fisher, The Rate of Interest: Its Nature,
Determination and Relation to Economic Phenomena
(New York: MacMillan Company, 1907), p. 152
Capital budgeting decisions involve the long-term commitment of a com-
pany’s scarce resources in long-term investments. These decisions play a

prominent role in determining whether a company will be successful. The
commitment of funds to a particular capital project can be enormous and
may be irreversible. Whereas some capital budgeting decisions are routine
decisions that do not change the course or risk of a company, there arestrategic capital budgeting decisions that will either have an impact on the
company’s future market position in its current product lines or permit it to
expand into a new product line in the future.

The company’s capital investment decision may be comprised of a num-
ber of distinct decisions, each referred to as a project . A capital project is a set
of assets that are contingent on one another and are considered together. Forexample, suppose a company is considering the production of a new prod-
uct. This capital project requires the company to acquire land, build facili-

ties, and purchase production equipment. And this project may also require
the company to increase its investment in its working capital—inventory,
295

296 VALUATION AND ANALYSIS TOOLS
cash, or accounts receivable. Working capital is the collection of assets
needed for day-to-day operations that support a company’s long-term
investments.
There are several techniques that are used in practice to evaluate capi-

tal budgeting proposals. Evaluating whether a company should invest in acapital project requires an analysis of whether the project adds value to thecompany. In this chapter we cover the capital budgeting decision. First, we
explain the capital budgeting process and the classiﬁcation of investment
projects. Second, we show how to estimate the expected change to a com-pany’s future cash ﬂow as a result of a capital investment decision. As will

become apparent, estimating cash ﬂow is an imprecise art at best. Finally,
we look at the techniques used to evaluate capital budgeting projects.
INVESTMENT DECISIONS AND OWNERS’ WEALTH
Managers must evaluate a number of factors in making investment deci-
sions. Not only does the ﬁnancial manager need to estimate how much the
company’s future cash ﬂows will change if it invests in a project, but themanager must also evaluate the uncertainty associated with these future
cash ﬂows.

cash ﬂows.
The value of the company today is the present value of all its future
cash ﬂows. But we need to understand better where these future cash ﬂowscome from. They come from assets that are already in place, which are the
assets accumulated as a result of all past investment decisions, and futureinvestment opportunities.
The value of a company is therefore the present value of the company’s

future cash ﬂows, where these future cash ﬂows include the cash ﬂows fromall assets in place and the cash ﬂows from future investment opportunities.
These future cash ﬂows are discounted at a rate that represents investors’
assessments of the uncertainty that these cash ﬂows will ﬂow in the amountsand when expected. As you can see, we need to evaluate the risk of these fu-
ture cash ﬂows in order to understand the risk of any investment opportunity
on the value of the company.

Cash ﬂow risk comes from two basic sources:
1. Sales risk. The degree of uncertainty related to the number of units that
will be sold and the price of the good or service.
2. Operating risk. The degree of uncertainty concerning operating cash
ﬂows that arises from the particular mix of ﬁxed and variable operatingcosts.

Capital Budgeting 297
Sales risk is related to the economy and the market in which the com-
pany’s goods and services are sold. Operating risk, for the most part, is
determined by the product or service that the company provides and is re-
lated to the sensitivity of operating cash ﬂows to changes in sales. We refer
to the combination of these two risks as business risk.

A project’s business risk is reﬂected in the discount rate, which is the rate
of return required to compensate the suppliers of capital (bondholders andowners) for the amount of risk they bear. From the perspective of investors,
the discount rate is the required rate of return (RRR). From the company’s
perspective, the discount rate is the cost of capital —what it costs the com-

pany to raise a dollar of new capital. The cost of capital and the required rateof return are the same concept, but from different perspectives: the cost ofcapital is generally from the perspective of the business enterprise, whereas
the required rate of return is from the perspective of the suppliers of capital,
the creditors and owners. Therefore, we will use the terms interchangeably inour study of capital budgeting. In the context of evaluating capital projects,

the cost of capital is the cost of raising new capital appropriate for the risk
of the project; hence, the cost of capital is project-speciﬁc.
For example, suppose a company invests in a new project, Project X.
How does the Project X affect the company’s value?
■If Project X generates cash ﬂows that just compensate the suppliers ofcapital for the risk they bear on this project (that is, it earns the cost of
capital), the value of the company does not change.

■If Project X generates cash ﬂows greater than needed to compensate
them for the risk they take on, it earns more than the cost of capital,
increasing the value of the company.
■If Project X generates cash ﬂows lessthan needed, it earns less than the
cost of capital, decreasing the value of the company.
How do we know whether the cash ﬂows are more than or less than
needed to compensate for the risk that they will indeed need? If we discount

all the cash ﬂows at the cost of capital, we can assess how this project affects
the present value of the company. If the expected change in the value of the
company from an investment is:
■Positive, the project returns more than the cost of capital, and therefore
it adds value to the company.
■Negative, the project returns less than the cost of capital, and therefore
it reduces the value of the company.

■Zero, the project returns the cost of capital, and therefore it does notaffect the value of the company.

298 VALUATION AND ANALYSIS TOOLS
Capital budgeting is the process of identifying and selecting investments
in long-lived assets; that is, selecting assets expected to produce beneﬁts over
more than one year.
THE CAPITAL BUDGETING PROCESS
Because a company must continually evaluate possible investments, capital
budgeting is an ongoing process. However, before a company begins think-

ing about capital budgeting, it must ﬁrst determine its corporate strategy—its broad set of objectives for future investment. For example, the Walt
Disney Company has stated that its objective is to “be one of the world’s
leading producers and providers of entertainment and information, usingits portfolio of brands to differentiate its content, services, and consumer
products.”
How does a company achieve its corporate strategy? This is accom-

plished by making investments in long-lived assets that maximize owners’wealth. Selecting these projects is what capital budgeting is all about.
Stages in the Capital Budgeting Process
Though every company has its own set of procedures and processes for
capital budgeting, we can generalize the process as consisting of ﬁve stages,
as we illustrate in Exhibit 13.1.
Stage 1: Investment Screening and Selection
Projects consistent with the corporate strategy are identiﬁed by

Capital Budgeting 299
by estimating how they affect the future cash ﬂows of the company
and, hence, the value of the company.
Stage 2: Capital Budgeting Proposal
A capital budget is proposed for the projects surviving the
screening and selection process. The budget lists the recommendedprojects and the dollar amount of investment needed for each.

This proposal may start as an estimate of expected revenues and
costs, but as the project analysis is reﬁned, data from marketing,
purchasing, engineering, accounting, and ﬁnance functions are put
together.
Stage 3: Budgeting Approval and Authorization
Projects included in the capital budget are authorized, allowing
further fact gathering and analysis, and approved, allowing expen-ditures for the projects. In some companies, the projects are autho-

rized and approved at the same time. In others, a project must ﬁrst
be authorized, requiring more research before it can be formallyapproved. Formal authorization and approval procedures are typ-
ically used on larger expenditures; smaller expenditures are at the
discretion of management.
Stage 4: Project Tracking
After a project is approved, work on it begins. The manager
reports periodically on its expenditures, as well as on any rev-

enues associated with it. This is referred to as project tracking ,
the communication link between the decision makers and the op-
erating management of the company. For example, tracking can
identify cost over-runs and uncover the need for more marketing
research.
Stage 5: Post-completion Audit
No matter the number of stages in a company’s capital
budgeting process, most companies include some form of post-
completion audit that involves a comparison of the actual cash from

operations of the project with the estimated cash ﬂow used to justifythe project. There are two reasons why the post-completion audit
is beneﬁcial. First, many companies ﬁnd that the knowledge that a
post-completion audit will be undertaken causes project proposersto be more careful before endorsing a project. Second, it will help se-
nior management identify proposers who are consistently optimistic

or pessimistic with respect to cash ﬂow estimates. Senior manage-ment will then be in a better position to evaluate the bias that
may be expected when a particular individual or group proposes
a project.

300 VALUATION AND ANALYSIS TOOLS
Classifying Investment Projects
Financial decision-makers may classify projects in different ways, based on
the projects’ useful life, risk, or dependence on other projects. Classifying
projects may help the decision-maker in terms of estimating the cash ﬂows

of the projects and the methods used to analyze the projects. We take a brieflook at the different ways projects may be classiﬁed.
Classifying by Economic Life An investment generally provides beneﬁts
over a limited period of time, referred to as its economic life. The economic
life or useful life of an asset is determined by factors including physical
deterioration, obsolescence, and the degree of competition in the market fora product.

The economic life is an estimate of the length of time that the asset will
provide beneﬁts to the company. After its useful life, the revenues generatedby the asset tend to decline rapidly and its expenses tend to increase.
Typically, an investment requires expenditures up front—immediately
—and provides beneﬁts in the form of cash ﬂows received in the future.If beneﬁts are received only within the current period—within one year of

making the investment—we refer to the Project X as a short-term investment.
If these beneﬁts are received beyond the current period, we refer to theProject X as a long-term project and refer to the expenditure as a capital
expenditure.
Any project representing an investment may comprise one or more as-
sets. For example, a new product may require investment in production

equipment, a building, and transportation equipment—all making up thebundle of assets comprising the project we are evaluating. Short-term in-
vestment decisions involve, primarily, investments in current assets: cash,
marketable securities, accounts receivable, and inventory. The objective ofinvesting in short-term assets is the same as long-term assets: maximizing
owners’ wealth. Nevertheless, we consider them separately for two practical
reasons:

reasons:
1.Decisions about long-term assets are based on projections of cash ﬂows
far into the future and require us to consider the time value of money.
2.Long-term assets do not ﬁgure into the daily operating needs of thecompany.
Decisions regarding short-term investments, or current assets, are con-
cerned with day-to-day operations. And a company needs some level of
current assets to act as a cushion in case of unusually poor operating peri-

Capital Budgeting 301
Classifying by Risk Suppose you are faced with two investments, A and B,
each promising a $100 cash inﬂow 10 years from today. If A is riskier than
B, what are they worth to you today? If you do not like risk, you would
consider A less valuable than B because the chance of getting the $100

in 10 years is less for A than for B. Therefore, valuing a project requiresconsidering the risk associated with its future cash ﬂows.
The project’s risk of return can be classiﬁed according to the nature of
the project represented by the investment:
■Replacement projects: investments in the replacement of existing equip-
ment or facilities.
■Expansion projects: investments in projects that broaden existing prod-
uct lines and existing markets.

■New products and markets: projects that involve introducing a new
product or entering into a new market.
■Mandated projects: projects required by government laws or agency
rules.
Replacement projects include the maintenance of existing assets to con-
tinue the current level of operating activity. Projects that reduce costs, such
as replacing older technology with newer technology or improving the efﬁ-

ciency of equipment or personnel, are also considered replacement projects.
To evaluate replacement projects we need to compare the value of the
company with the replacement asset to the value of the company withoutthat same replacement asset. What we’re really doing in this comparisonis looking at opportunity costs: what cash ﬂows would have been if the
company had stayed with the old asset.
There’s little risk in the cash ﬂows from replacement projects. The com-

pany is simply replacing equipment or buildings already operating and pro-ducing cash ﬂows. And the company typically has experience in managing
similar new equipment.
Expansion projects are intended to enlarge a company’s established
product or market. There is little risk associated with expansion projects.The reason: A company with a history of experience in a product or mar-
ket can estimate future cash ﬂows with more certainty when consider-

ing expansion than when introducing a new product outside its existingproduct line.
Investment projects that involve introducing new products or entering
into new markets are riskier than the replacement and expansion projects.That’s because the company has little or no management experience in the
new product or market. Hence, there is more uncertainty about the future
cash ﬂows from investments in new product or new market projects.

302 VALUATION AND ANALYSIS TOOLS
A company is forced or coerced into its mandated projects . These are
government mandated projects typically found in “heavy” industries, such
as utilities, transportation, and chemicals, all industries requiring a large por-tion of their assets in production activities. Government agencies, such as

the Occupational Safety and Health Administration (OSHA) or the Environ-
mental Protection Agency (EPA), may impose requirements that companiesinstall speciﬁc equipment or alter their activities, such as how they dispose
of waste or remediate property.
Classifying by Dependence on Other Projects In addition to consid-
ering the future cash ﬂows generated by project, a company must con-
sider how it affects the assets already in place—the results of previous

project decisions—as well as other projects that may be undertaken. Projectscan be classiﬁed as follows according to the degree of dependence with
other projects: independent projects, mutually exclusive projects, contingent
projects, and complementary projects.
Anindependent project is one whose cash ﬂows are not related to the

cash ﬂows of any other project. In other words, accepting or rejecting anindependent project does not affect the acceptance or rejection of otherprojects. An independent project can be evaluated strictly on the effect it
will have on the value of a company without having to consider how it
affects the company’s other investment opportunities, and vice versa.
Projects are mutually exclusive projects if the acceptance of one pre-

cludes the acceptance of other projects. There are some situations where itis technically impossible to take on more than one project. For example,suppose a manufacturer is considering whether to replace its production fa-
cilities with more modern equipment. The company may solicit bids among
the different manufacturers of this equipment. The decision consists of com-paring two choices:
1.Keeping its existing production facilities, or

2.Replacing the facilities with the modern equipment of one manufacturer.
Because the company cannot use more than one production facility, it
must evaluate each bid and determine the most attractive one. The alternative
production facilities are mutually exclusive projects: the company can acceptonly one bid. The alternatives of keeping existing facilities or replacing them

are also mutually exclusive projects. The company cannot keep the existing
facilities and replace them!
Contingent projects are dependent on the acceptance of another project.
For example, toy and video-game tie-in agreements with movies are de-pendent on the movie coming to the market. Or, as another example, the

Capital Budgeting 303
manufacturer of an automobile part, such as a speciﬁcally-designed electric
window, is contingent on the sale of the automobile.
Another form of dependence is found in complementary projects.

Projects are complementary projects if the investment in one enhances thecash ﬂows of one or more other projects. Consider a manufacturer of per-sonal computer equipment. The sale of computers that have video-gaming
capabilities may spur sales of video-games or video-game controls.
DETERMINING CASH FLOWS FROM INVESTMENTS
A company invests only to make its owners “better off,” meaning increasing

the value of their ownership interest. A company will have cash ﬂows in thefuture from its past investment decisions. When it invests in new assets, it
expects the future cash ﬂows to be greater than without this new investment.
Otherwise it doesn’t make sense to make this investment. The differencebetween the cash ﬂows of the company with the investment project and the
cash ﬂows of the company without the investment project—both over the

same period of time—is referred to as the project’s incremental cash ﬂows .
To evaluate an investment, we’ll have to look at how it will change the
future cash ﬂows of the company. In other words, we examine how much thevalue of the company changes as a result of the investment. The change in
a company’s value as a result of a new investment is the difference between
its beneﬁts and its costs:
Change in the value of the company =Project’s beneﬁts −Project’s costs

A more useful way of evaluating the change in the value is the breakdown
the project’s cash ﬂows into two components:
1.The present value of the cash ﬂows from the project’s operating activities(revenues and operating expenses), referred to as the project’s operating
cash ﬂows (OCF); and
2.The present value of the investment cash ﬂows, which are the expen-ditures needed to acquire the project’s assets and any cash ﬂows from
disposing the project’s assets.
or,

or,
Change in the value of the company =Present value of the change in
operating cash ﬂows +Present value of investment cash ﬂows

304 VALUATION AND ANALYSIS TOOLS
The present value of a project’s operating cash ﬂows is typically pos-
itive (indicating predominantly cash inﬂows) and the present value of the
investment cash ﬂows is typically negative (indicating predominantly cash
outﬂows).
Investment Cash Flows
When we consider the cash ﬂows of an investment we must also consider

all the cash ﬂows associated with acquiring and disposing of assets in the
investment. An investment may comprise:
■one asset or many assets;
■an asset purchased and another sold; and
■cash outlays that occur at the beginning of the project or spread over
several years.
Let’s ﬁrst become familiar with cash ﬂows related to acquiring assets;
then we’ll look at cash ﬂows related to disposing assets.Asset Acquisition In acquiring any asset, there are three cash ﬂows to
consider:

consider:
1.The cost of the asset,
2.Set-up expenditures, including shipping and installation; and
3.Any tax credit.The tax credit may be an investment tax credit or a special credit—such
as a credit for a pollution control device—depending on the tax law. The
cash ﬂow associated with acquiring an asset is:
Cash ﬂow from acquiring assets =Cost+Set-up expenditures +Tax credit.
Suppose the company buys equipment that costs $100,000 and it costs

$10,000 to install. If the company is eligible for a 10% tax-credit on this
equipment (that is, 10% of the total cost of buying and installing the equip-
ment), the change in the company’s cash ﬂow from acquiring the asset is
$99,000:
Cash ﬂow from
acquiring assets=−$100,000 −10,000 +0.10 ($100,000 +10,000)
=−$100,000 −10,000 +$11,000
=−$99,000

Capital Budgeting 305
The cash outﬂow is −$99,000 when this asset is acquired: −$110,000
to buy and install the equipment and $11,000 in from the reduction in taxes.
What about expenditures made in the past for assets or research that
would be used in the project we’re evaluating? Suppose the company spent

$1,000,000 over the past three years developing a new type of toothpaste.Should the company consider this $1,000,000 spent on research and devel-
opment when deciding whether to produce this new project we are consider-
ing? No! These expenses have already been made and do not affect how thenew product changes the future cash ﬂows of the company. We refer to this
$1,000,000 as a sunk cost and do not consider it in the analysis of our new

project. Whether or not the company goes ahead with this new product, this$1,000,000 has been spent. A sunk cost is any cost that has already been
incurred that does not affect future cash ﬂows of the company.
Let’s consider another example. Suppose the company owns a building

that is currently empty. Let’s say the company suddenly has an opportunityto use it for the production of a new product. Is the cost of the buildingrelevant to the new product decision? The cost of the building itself is a
sunk cost because it was an expenditure made as part of some previous
investment decision. The cost of the building does not affect the decision togo ahead with the new product.
Suppose the company is using the building in some way producing cash

(i.e., renting it) and the new project is going to take over the entire building.The cash ﬂows given up represent opportunity costs that must be included
in the analysis of the new project. However, these forgone cash ﬂows are
not asset acquisition cash ﬂows. Because they represent operating cash ﬂowsthat could have occurred, but will not because of the new project, they must
be considered part of the project’s future operating cash ﬂows. Further, if we

incur costs in renovating the building to manufacture the new product, therenovation costs are relevant and should be included in our asset acquisition
cash ﬂows.
EXAMPLE 13.1: INITIAL CASH FLOW
Suppose a company spends $1 million on research and development
of a new drug. The cost to buy the necessary equipment to produce
and distribute the drug is $2.5 million. Working capital is expected to

increase by $250,000 when the company embarks on the new product.What is the initial cash ﬂow for this project?

306 VALUATION AND ANALYSIS TOOLS
Solution
Cash Flow
Cost of equipment −$2,500,000
Increase in working capital −250,000
Initial cash ﬂow −$2,750,000
Asset Disposition Many new investments require getting rid of old assets.
At the end of the useful life of an asset, the company may be able to sell it
or may have to pay someone to haul it away. If the company is making a

decision that involves replacing an existing asset, the cash ﬂow from dispos-
ing of the old asset must be included because it is a cash ﬂow relevant to the
acquisition of the new asset.
If the company disposes of an asset, whether at the end of its useful life
or when it is replaced, we must consider two types of cash ﬂows:
1.what you receive or pay in disposing of the asset; and
2.any tax consequences resulting from the disposal.
or
disposing assets=Proceeds or payment

from disposing assets−Taxes from
disposing assets
The proceeds are what you expect to sell the asset for if you can get
someone to buy it. If the company must pay for the disposal of the asset,this cost is a cash outﬂow.
Consider the investment in a dry cleaner. The current owner may want
to leave the business (retire, whatever), selling the dry cleaning business toanother dry cleaner proprietor. But if a buyer cannot be found because of

lack of buyers in the area, the current owner may be required to mitigate
the site for any environmental damage from the solvents. Thus, a cost is
incurred at the end of the asset’s life.
The tax consequences are a bit more complicated. Taxes depend on:
■the expected sales price, and
■the book value of the asset for tax purposes at the time of disposition.

Capital Budgeting 307
If a company sells the asset for more than its book value but less than
its original cost, the difference between the sales price and the book value is
a gain, taxable at ordinary tax rates. If a company sells the asset for more
than its original cost, then the gain is broken into two parts:

1.Capital gain: the difference between the sales price and the original cost;
and
2.Recapture of depreciation: the difference between the original cost and
the book value.
The capital gain is the beneﬁt from the appreciation in the value of the
asset and may be taxed at special rates, depending on the tax law at the
time of sale. The recapture of depreciation represents the amount by which
the company has over-depreciated the asset during its life. This means that

more depreciation has been deducted from income (reducing taxes) thannecessary to reﬂect the usage of the asset. The recapture portion is taxed at
the ordinary tax rates, since this excess depreciation taken all these years
has reduced taxable income.
If a company sells an asset for less than its book value, the result is
a capital loss. In this case, the asset’s value has decreased by more thanthe amount taken for depreciation for tax purposes. A capital loss is givenspecial tax treatment:

■If there are capital gains in the same tax year as the capital loss, they
are combined, so that the capital loss reduces the taxes paid on capital
gains, and
■If there are no capital gains to offset against the capital loss, the capitalloss is used to reduce ordinary taxable income.
The beneﬁt from a loss on the sale of an asset is the amount by which
taxes are reduced. The reduction in taxable income is referred to as a tax

shield, since the loss shields some income from taxation. If the company has
a loss of $1,000 on the sale of an asset and has a tax rate of 40%, this meansthat its taxable income is $1,000 less and its taxes are $400 less than they
would have been without the sale of the asset.
We summarize the breakdown of gains on sales of assets in Exhibit 13.2.
The key is to compare the sales price of the asset with its original cost andbook value.

Suppose you are evaluating an asset that costs $10,000 that you expect
to sell in ﬁve years. Suppose further that the book value of the asset for taxpurposes will be $3,000 after ﬁve years and that the company’s tax rate is
40%. What are the expected cash ﬂows from disposing this asset? If you

308 VALUATION AND ANALYSIS TOOLS
Sales price > Original cost
Recapture =
Original cost– Book valueLoss =
Book value – Sales priceRecapture =
Original cost– Book valueCapital gain =
Sales price – Original costOriginal cost > Sales price
> Book valueBook value > Sales price
EXHIBIT 13.2 Gains and Losses on Sales
expect the company to sell the asset for $8,000 in ﬁve years, $10,000 −

3,000 =$7,000 of the asset’s cost will be depreciated, yet the asset lost
only $10,000 −8,000 =$2,000 in value. Therefore, the company has over-
depreciated the asset by $5,000. Because this over-depreciation represents
deductions to be taken on the company’s tax returns over the ﬁve years that
don’t reﬂect the actual depreciation in value (the asset doesn’t lose $7,000

in value, only $2,000), this $5,000 is taxed at ordinary tax rates. If thecompany’s tax rate is 40%, the tax is 40% ×$5,000, or $2,000.
The cash ﬂow from disposition is the sum of the direct cash ﬂow (some-
one pays us for the asset or the company pays someone to dispose of it)and the tax consequences. In this example, the cash ﬂow is the $8,000 we
expect someone to pay the company for the asset, less the $2,000 in taxes
we expect the company to pay, or $6,000 cash inﬂow.

Suppose instead that you expect the company to sell this asset in ﬁve
years for $12,000. Again, the asset is over-depreciated by $7,000. In fact,the asset is not expected to depreciate, but rather appreciate over the ﬁveyears. The $7,000 in depreciation is recaptured after ﬁve years and taxed
at ordinary rates: 40% of $7,000, or $2,800. The $2,000 capital gain is
the appreciation in the value of the asset and may be taxed at special rates.

If the tax rate on capital gain income is 30%, you expect the company to
pay 30% of $2,000, or $600 in taxes on this gain. Selling the asset in ﬁveyears for $12,000 therefore results in an expected cash inﬂow of $12,000 −
2,800 −600=$8,600.
Suppose you expect the company to sell the asset in ﬁve years for $1,000.
If the company can reduce its ordinary taxable income by the amount of the
capital loss, $3,000 −1,000 =$2,000, our tax will be 40% of $2,000, or

$800 because of this loss. We refer to this reduction in the taxes as a tax
shield, since the loss “shields” $2,000 of income from taxes. Combining the
$800 tax reduction with the cash ﬂow from selling the asset, the $1,000,
gives the company a cash inﬂow of $1,800.

Capital Budgeting 309
Let’s also not forget about disposing of any existing assets. Suppose the
company bought equipment 10 years ago and at that time expected to be able
to sell ﬁfteen years later for $10,000. If the company decides today to replace
this equipment, it must consider what it is giving up by not disposing of an

asset as planned. If the company does not replace the equipment today,it would continue to depreciate it for ﬁve more years and then sell it for
$10,000; if the company replaces the equipment today, it would not have
ﬁve more years’ depreciation on the replaced equipment and it would nothave $10,000 in ﬁve years (but perhaps some other amount today). This
$10,000 in ﬁve years, less any taxes, is a forgone cash ﬂow that we must

ﬁgure into the investment cash ﬂows. Also, the depreciation the companywould have had on the replaced asset must be considered in analyzing the
replacement asset’s operating cash ﬂows.
TRY IT! DISPOSITION CASH FLOWS,
USING STRAIGHT-LINE
Consider equipment that is bought for $500,000. Suppose it is depre-
ciated over four years at a straight-line rate of 25% per year. At the
end of two years, the equipment is sold for $100,000. What is the cash
ﬂow effect of this sale? Assume a 35% tax rate.

Operating Cash Flows
In the simplest form of investment, there will be a cash outﬂow when the as-set is acquired and there may be either a cash inﬂow or an outﬂow at the
end of its economic life. In most cases these are not the only cash ﬂows—the
investment may result in changes in revenues, expenditures, taxes, and work-

ing capital. These are operating cash ﬂows because they result directly fromthe operating activities—the day-to-day activities of the company.
What we are after here are estimates of operating cash ﬂows. We cannot
know for certain what these cash ﬂows will be in the future, but we mustattempt to estimate them. What is the basis for these estimates? We base them
on marketing research, engineering analyses, operations research, analysis
of our competitors—and our managerial experience.

The key in the analysis of operating cash ﬂows is to determine the
incremental cash ﬂows: “How are the cash ﬂows of the company expectedto change when the new project is undertaken?”

310 VALUATION AND ANALYSIS TOOLS
Change in Revenues Suppose we are a food processor considering a new
investment in a line of frozen dinner products. If we introduce a new ready-
to-eat dinner product that is not frozen, our marketing research will indi-
cate how much we should expect to sell. But where do these new product

sales come from? Some may come from consumers who do not alreadybuy frozen dinner products. But some of the not-frozen dinner product
sales may come from consumers who choose to buy the not-frozen din-
ner product instead of frozen dinners. It would be nice if these consumersare giving up buying our competitors’ frozen dinners. Yet some of them
may be giving up buying our frozen dinners. So, when we introduce a new

product, we are really interested in how it changes the sales of the entirecompany (that is, the incremental sales), rather than the sales of the new
product alone.
We also need to consider any foregone revenues—opportunity
costs—related to our investment. Suppose our company owns a building
currently being rented to another company. If we are considering termi-nating that rental agreement so we can use the building for a new project,

we need to consider the foregone rent—what we would have earned from
the building. Therefore, the revenues from the new project are really only theadditional revenues—the revenues from the new project minus the revenue
we could have earned from renting the building.
So, when a company undertakes a new project, the ﬁnancial managers
want to know how it changes the company’s total revenues, not merely thenew product’s revenues.

Change in Expenses When a company takes on a new project, all the costs
associated with it change the company’s expenses. If the investment involves
changing the sales of an existing product, we need an estimate the changein unit sales. Once we have an estimate in how sales may change, we can
develop an estimate of the additional costs of producing the additional num-
ber of units by consulting with production management. And, we will want

an estimate of how the product’s inventory may change when production
and sales of the product change.
If the investment involves changes in the costs of production, we com-
pare the costs without this investment with the costs with this investment.For example, if the investment is the replacement of an assembly line ma-chine with a more efﬁcient machine, we need to estimate the change in the
company’s overall production costs such as electricity, labor, materials, and
management costs.

A new investment may change not only production costs but also op-
erating costs, such as rental payments and administration costs. Changes in

Capital Budgeting 311
operating costs as a result of a new investment must be considered as part
of the changes in the company’s expenses. Increasing cash expenses are cashoutﬂows, and decreasing cash expenses are cash inﬂows.
Change in Taxes Taxes ﬁgure into the operating cash ﬂows in two ways.
First, if revenues and expenses change, taxable income and, therefore, taxes

change. That means we need to estimate the change in taxable income result-
ing from the changes in revenues and expenses resulting from a new project
to determine the effect of taxes on the company. Second, the deduction fordepreciation reduces taxes. Depreciation itself is not a cash ﬂow. But depre-
ciation reduces the taxes that must be paid, shielding income from taxation.
The tax shield from depreciation is like a cash inﬂow.

Suppose a company is considering a new product that is expected to
generate additional sales of $200,000 and increase expenses by $150,000.If the company’s tax rate is 40%, considering only the change in sales and
expenses, taxes go up by $50,000 ×40% or $20,000. This means that the
company is expected to pay $20,000 more in taxes because of the increase
in revenues and expenses.
Let’s change this around and consider that the product will generate

$200,000 in revenues and $250,000 in expenses. Considering only thechange in revenues and expenses, if the tax rate is 40%, taxes go down
by $50,000 ×40%, or $20,000. This means that we reduce our taxes by
$20,000, which is like having a cash inﬂow of $20,000 from taxes.
Now, consider depreciation. When a company buys an asset that pro-
duces income, the tax laws allow it to depreciate the asset, reducing taxable

income by a speciﬁed percentage of the asset’s cost each year. By reducingtaxable income, the company is reducing its taxes. The reduction in taxes
is like a cash inﬂow since it reduces the company’s cash outﬂow to the
government.
Suppose a company has taxable income of $50,000 before depreciation
and a ﬂat tax rate of 40%. If the company is allowed to deduct depreciationof $10,000, how has this changed the taxes it pays?
Without Depreciation With Depreciation
Taxable income $50,000 $40,000

Tax rate ×0.40 ×0.40
Taxes $20,000 $16,000
Depreciation reduces the company’s tax-related cash outﬂow by
$20,000 −16,000 =$4,000 or, equivalently, by $10,000 ×40%=$4,000.

312 VALUATION AND ANALYSIS TOOLS
A reduction is an outﬂow (taxes in this case) is an inﬂow. We refer to the
effect depreciation has on taxes as the depreciation tax shield .
Depreciation itself is not a cash ﬂow. But in determining cash ﬂows,

we are concerned with the effect depreciation has on our taxes—and we allknow that taxes are a cash outﬂow. Because depreciation reduces taxable in-come, depreciation reduces the tax outﬂow, which amounts to a cash inﬂow.
For tax purposes, companies use accelerated depreciation; speciﬁcally,
the rates speciﬁed under the Modiﬁed Accelerated Cost Recovery System
(MACRS) or straight-line. An accelerated method is preferred in most situ-

ations because it results in larger deductions sooner in the asset’s life than
using straight-line depreciation. Therefore, accelerated depreciation, if avail-able, is preferable to straight-line due to the time value of money. We provide
the MACRS depreciation rates in Exhibit 13.3. Depreciable assets are clas-
siﬁed by type and the set of rates for that class prescribed by the U.S. Tax
Code. For example, a truck is classiﬁed as a 5-year MACRS asset, so the

rates associated with the 5-year column in Exhibit 13.3 are applied againstthe cost of the asset.
Suppose you have an asset that costs $100,000 and is considered a
3-year MACRS asset. What is the depreciation expense for tax purposeseach year? What is the depreciation tax shield each year? If you keep the
asset for ﬁve years and the tax rate is 35%,
Depreciation ExpenseEnding Book
ValueDepreciation
Tax Shield
Year$100,000 ×
MACRS RateOriginal Cost—
Accumulated
Depreciation Depreciation ×35%

1 $33,330 $66,670 $11,666
2 $44,450 $22,220 $15,558
3 $14,810 $7,410 $5,184
4 $7,410 $0 $2,594
5$ 0 $ 0 $ 0
Under the present tax code, assets are depreciated to a zero book value.
Salvage value—what we expect the asset to be worth at the end of its life—is
not considered in calculating depreciation. So is salvage value totally irrele-vant to the analysis? No. Salvage value is our best guess today of what the

asset will be worth at the end of its useful life, sometime in the future. In
other words, salvage value is our estimate of how much we can get when we

Capital Budgeting 313
EXHIBIT 13.3 MACRS Depreciation Rates
Year 3-Year 5-Year 7-Year 10-Year 15-Year
1 33.33% 20.00% 14.29% 10.00% 5.00%
2 44.45 32.00 24.49 18.00 9.50
3 14.81 19.20 17.49 14.40 8.55
4 7.41 11.52 12.49 11.52 7.705 11.52 8.93 9.22 6.93
6 5.76 8.92 7.37 6.23
7 8.93 6.55 5.90
8 4.46 6.55 5.90
9 6.56 5.91
10 6.55 5.90
11 3.28 5.91
12 5.90
13 5.91
14 5.90
15 5.91
16 2.95

12 5.90
13 5.91
14 5.90
15 5.91
16 2.95
dispose of the asset. Just remember you can’t use it to ﬁgure depreciation
for tax purposes.
Let’s look at another depreciation example, this time considering
the effect of replacing an asset has on the depreciation tax shield cash
ﬂow. Suppose you are replacing a machine that you bought ﬁve years agofor $75,000. You were depreciating this old machine using straight-line
depreciation over 10 years, or $7,500 depreciation per year. If you replace

it with a new machine that costs $50,000 and is depreciated over ﬁveyears, or $10,000 each year, how does the change in depreciation affect
the cash ﬂows if the company’s tax rate is 30%? We can calculate the effect
two ways:
1.We can compare the depreciation and related tax shield from the old
and the new machines. The depreciation tax shield on the old machine
is 30% of $7,500, or $2,250. The depreciation tax shield on the newmachine is 30% of $10,000, or $3,000. Therefore, the change in the

cash ﬂow from depreciation is $3,000 −$2,250 =$750.
2.We can calculate the change in depreciation and calculate the tax shield
related to the change in depreciation. The change in depreciation is
$10,000 −7,500 =$2,500. The change in the depreciation tax shield
is 30% of $2,500, or $750.

314 VALUATION AND ANALYSIS TOOLS
TRY IT! ASSET DISPOSITION CASH FLOWS,
USING MACRS
Consider equipment that is bought for $500,000. Suppose it is de-
preciated as a three-year MACRS asset. At the end of two years, theequipment is sold for $100,000. What is the cash ﬂow effect of this
sale? Assume a 35% tax rate.
Change in Working Capital

Working capital consists of short-term assets, also referred to as current
assets, which support the day-to-day operating activity of the business. Networking capital is the difference between current assets and current liabili-
ties. Net working capital is what would be left over if the company had to
pay off its current obligations using its current assets. The adjustment wemake for changes in net working capital is attributable to two sources:

1.a change in current asset accounts for transactions or precautionaryneeds; and
2.the use of the accrual method of accounting.
An investment may increase the company’s level of operations, resulting
in an increase in the net working capital needed (also considered transac-
tions needs). If the investment is to produce a new product, the company
may have to invest more in inventory (raw materials, work-in-process, andﬁnished goods). If to increase sales means extending more credit, then the

company’s accounts receivable will increase. If the investment requires main-
taining a higher cash balance to handle the increased level of transactions,
the company will need more cash. If the investment makes the company’s
production facilities more efﬁcient, it may be able to reduce the level ofinventory.
Because of an increase in the level of transactions, the company may

want to keep more cash and inventory on hand for precautionary pur-poses. That is because as the level of operations increase, the effect of any
ﬂuctuations in demand for goods and services may increase, requiring the
company to keep additional cash and inventory “just in case.” The companymay increase working capital as a precaution because if there is greater vari-
ability of cash and inventory, a greater safety cushion will be needed. On

the other hand, if a project enables the company to be more efﬁcient or

Capital Budgeting 315
lowers costs, it may lower its investment in cash, marketable securities, or
inventory, releasing funds for investment elsewhere in the company.
We also use the change in working capital to adjust accounting income

(revenues less expenses) to a cash basis because cash ﬂow is ultimately whatwe are valuing, not accounting numbers. But since we generally have onlythe accounting numbers to work from, we use this information, making
adjustments to arrive at cash.
To see how this works, let’s look at the cash ﬂow from sales. Not every
dollar of sales is collected in the year of sale. Customers may pay some timeafter the sale. Using information from the accounts receivable department

about how payments are collected, we can determine the change in the cashﬂows from revenues. Suppose we expect sales in the ﬁrst year to increase
by $20,000 per month and it typically takes customers thirty days to pay.
The change in cash ﬂows from sales in the ﬁrst year is $20,000 ×11=
$220,000—not $20,000 ×12=$240,000. The way we adjust for this
difference between what is sold and what is collected in cash is to keeptrack of the change in working capital, which is the change in accounts

receivable in this case. An increase in working capital is used to adjust
revenues downward to calculate cash ﬂow:
Change in revenues $240,000
Less: Increase in accounts receivable 20,000
Change in cash inﬂow from sales $220,000
On the other side of the balance sheet, if the company is increasing its
purchases of raw materials and incurring more production costs, such aslabor, the company may increase its level of short-term liabilities, such as
accounts payable and salary and wages payable.

Suppose expenses for materials and supplies are forecasted at $10,000
per month for the ﬁrst year and it takes the company thirty days to pay.Expenses for the ﬁrst year are $10,000 ×12=$120,000, yet cash outﬂow
for these expenses is only $10,000 ×11=$110,000 since the company
does not pay the last month’s expenses until the following year. Accountspayable increases by $10,000, representing one month of expenses. The

increase in net working capital (increase in accounts payable /brightincreases
current liabilities /brightincreases net working capital) reduces the cost of goods
sold to give us the cash outﬂow from expenses:
Cost of goods sold $120,000
Less: increase in accounts payable 10,000
Change in cash ﬂow from expenses $110,000

316 VALUATION AND ANALYSIS TOOLS
A new project may result in either:
■an increase in net working capital;
■a decrease in net working capital; or
■no change in net working capital.
CLASSIFYING WORKING CAPITAL CHANGES
In many applications, we can arbitrarily classify the change in working
capital as either investment cash ﬂows or operating cash ﬂows. And

the classiﬁcation doesn’t really matter since it’s the bottom line, the net
cash ﬂows, that matter. How we classify the change in working capital
doesn’t affect a project’s attractiveness.
Further, working capital may change at the beginning of the project
and at any point during the life of the project. For example, as a new
product is introduced, sales may be terriﬁc in the ﬁrst few years, requiring
an increase in cash, accounts receivable, and inventory to support these

increased sales. But all of this requires an increase in working capital—a cashoutﬂow.
But later sales may fall off as competitors enter the market. As sales
and production fall off, the need for the increased cash, accounts receivable,and inventory falls off also. As cash, accounts receivable, and inventory are
reduced, there is a cash inﬂow in the form of the reduction in the funds that
become available for other uses within the company.

A change in net working capital can be thought of speciﬁcally as part
of the initial investment—the amount necessary to get the project going. Orit can be considered generally as part of operating activity—the day-to-day
business of the company. So where do we classify the cash ﬂow associ-
ated with net working capital? With the asset acquisition and dispositionrepresented in the new project or with the operating cash ﬂows?
If a project requires a change in the company’s net working capital

accounts that persists for the duration of the project—say, an increase ininventory levels starting at the time of the investment—we tend to classify
the change as part of the acquisition costs at the beginning of the project and
as part of disposition proceeds at the end of project. If, on the other hand,the change in net working capital is due to the fact that accrual accounting
does not coincide with cash ﬂows, we tend to classify the change is part of
the operating cash ﬂows.

Capital Budgeting 317
Putting It All Together Here’s what we need to put together to calculate
the change in the company’s operating cash ﬂows related to a new investment
we are considering:
■Changes in revenues and expenses;
■Cash ﬂow from changes in taxes from changes in revenues and expenses;
■Cash ﬂow from changes in cash ﬂows from depreciation tax shields; and

■Changes in net working capital.
There are many ways of compiling the component cash ﬂow changes to
arrive at the change in operating cash ﬂow. We will start by ﬁrst calculating
taxable income, making adjustments for changes in taxes, non cash expenses,
and net working capital to arrive at operating cash ﬂow.
Suppose you are evaluating a project that is expected to increase sales by

$200,000 and expenses by $150,000. Accounts receivable are expected to in-crease by $20,000 and accounts payable are expected to increase by $5,000,
but no changes in cash or inventory are expected. Further, suppose theproject’s assets will have a $10,000 depreciation expense for tax purposes.
If the tax rate is 40%, what is the operating cash ﬂow from this project?
Change in sales $200,000
Less Change in expenses 150,000
Less Change in depreciation 10,000

Equals Change in taxable income $40,000
Less Taxes 16,000
Equals Change in income after taxes $24,000
Plus Depreciation 10,000
Less Increase in working capital 15,000
Equals Change in operating cash ﬂow $19,000
So that we can mathematically represent how to calculate the change
in operating cash ﬂows for a project, let’s use the symbol “/Delta1” to indicate
“change in”:
/Delta1OCF =change in operating cash ﬂow;
/Delta1R=change in revenues;

/Delta1E=change in expenses;
/Delta1D=change in depreciation;
t=tax rate; and
/Delta1NWC =change in working capital

318 VALUATION AND ANALYSIS TOOLS
The change in the operating cash ﬂow is:
/Delta1OCF =(/Delta1R−/Delta1E−/Delta1D) (1 −t)+/Delta1D−/Delta1NWC
We can also write this as:
/Delta1OCF =(/Delta1R−/Delta1E) (1 −t)+/Delta1Dt−/Delta1NWC
Applying these equations to the previous example,
/Delta1OCF =(/Delta1R−/Delta1E−/Delta1D)×(1−t)+/Delta1D−/Delta1NWC

/Delta1OCF =($200,000 −150,000 −10,000) ×(1−0.40) +$10,000
−$15,000
/Delta1OCF =$19,000
or, using the rearrangement of the equation,
/Delta1OCF =($200,000 −150,000) ×(1−0.40) +($10,000 ×0.40)
−$15,000
/Delta1OCF =$19,000 .
Let’s look at one more example for the calculation of operating cash
ﬂows. Suppose you are evaluating modern equipment which you expect

will reduce expenses by $100,000 during the ﬁrst year. And, since the newequipment is more efﬁcient, you can reduce the level of inventory by $20,000
during the ﬁrst year. The old machine cost $200,000 and was depreciated
using straight-line over 10 years, with ﬁve years remaining. The new machinecost $300,000 and will be depreciated using straight-line over 10 years. If
the company’s tax rate is 30%, what is the expected operating cash ﬂow in
the ﬁrst year? Let’s identify the components:

/Delta1R=$0 The new machine does not affect revenues.
/Delta1E=− $100,000 The new machine reduces expenses that will
reduce taxes and increase cash ﬂows.
/Delta1D=+ 10,000 The new machine increases the depreciation
expense from $20,000 to $30,000.
/Delta1NWC =− $20,000 The company can reduce its investment in
inventory releasing funds to be investedelsewhere.
t=30%

Capital Budgeting 319
The operating cash ﬂow from the ﬁrst year is therefore:
/Delta1OCF =($100,000 −10,000) ×(1−0.30) +$10,000 −$20,000
/Delta1OCF =$63,000 +$10,000 +$20,000
/Delta1OCF =$93,000
EXAMPLE 13.2: CHANGE IN DEPRECIATION
Suppose the Inter.Com Company is evaluating its depreciation methods

on a new piece of equipment that costs $100,000. And suppose theequipment can be depreciated using straight-line over ﬁve years or
treating it as a 3-year MACRS asset. What is the difference in the cash
ﬂows associated with depreciation under these two methods in thesecond year if its marginal tax rate is 40%?
Solution
Difference in depreciation =$20,000 – 44,450 =$24,450
Tax shield of difference =0.40×$24,450 =$9,780
TRY IT! CHANGE IN EXPENSES

If a project is expected to increase costs by $50,000 per year and the
tax rate of the company is 40%, what is the net cash ﬂow from the
change in costs?
Net Cash Flows By now we should know that an investment’s cash
ﬂows consist of: (1) cash ﬂows related to acquiring and disposing the
assets represented in the investment, and (2) how it affects cash ﬂowsrelated to operations. To evaluate any investment project, we must con-

sider both to determine whether or not the company is better off with or
without it.

320 VALUATION AND ANALYSIS TOOLS
The sum of the cash ﬂows from asset acquisition and disposition and
from operations is the net cash ﬂows (NCF). And this sum is calculated for
each period. In each period, we add the cash ﬂow from asset acquisition and
disposition and the cash ﬂow from operations. For a given period,
Net cash ﬂow =Investment cash ﬂow +Change in operating cash ﬂow

The analysis of the cash ﬂows of investment projects can become quite
complex. But by working through any problem systematically, line-by-line,
you will be able to sort out the information and focus on those items that
determine cash ﬂows.
A Comprehensive Example
The Acme.Com Company is evaluating replacing its production equipment
that produces anvils. The current equipment was purchased 10 years agoat a cost of $1.5 million. Acme depreciated its current equipment using

MACRS, considering the equipment to be a 5-year MACRS asset. If they
sell the current equipment, they estimate that they can get $100,000.
The new equipment would cost $2.5 million and would be depreciated
as a 5-year MACRS asset. The new equipment would not affect sales, butwould result in a costs savings of $400,000 each year of the asset’s 10-yearuseful life.
At the end of its 10-year life, Acme estimates that it can sell the equip-

ment for $30,000. Also, because the new equipment would be more ef-ﬁcient, Acme would have less work-in-process anvils, reducing inventory
needs initially by $20,000. Acme’s marginal tax rate is 40%. Assume that
the equipment purchase (and sale of the old equipment) occurs at the end ofYear 0 and that the ﬁrst year of operating this equipment is Year 1 and the
last year of operating the equipment is Year 10.
From this scenario, we can pick out pieces of information that we need
in our analysis:

■Book value of existing equipment =$0
■Sale of current equipment =$100,000 cash inﬂow
■Tax on sale of current equipment =$40,000 cash outﬂow
■Initial outlay for new =$2,500,000 cash outﬂow
■/Delta1R=$0
■/Delta1E=$400,000 each year
■/Delta1WC =−$20,000 cash outﬂow initially
■/Delta1WC =$20,000 cash inﬂow at the end of project

Capital Budgeting 321
The depreciation on the new equipment, based on MACRS rates, is:
Year Calculation Depreciation expense
1 0.2000 ×$2,500,000 $500,000
2 0.3200 ×$2,500,000 $800,000
3 0.1920 ×$2,500,000 $480,000
4 0.1152 ×$2,500,000 $288,000
5 0.1152 ×$2,500,000 $288,000
6 0.0576 ×$2,500,000 $144,000
There is no depreciation expense after Year 6.

We provide the cash ﬂow calculations in Exhibit 13.4. The net cash ﬂow
initially is negative, but then is positive for each year thereafter.
Simplifications To actually analyze a project’s cash ﬂows, we need to make
several simpliﬁcations:
■We assume that cash ﬂows into or out of the company at certain points
in time, typically at the end of the year, although we realize a project’scash ﬂows into and out of the company at irregular intervals.

■We assume that the assets are purchased and put to work immediately.
■By combining inﬂows and outﬂows in each period, we are assuming thatall inﬂows and outﬂows in a given period have the same risk.
Because there are so many ﬂows to consider, we focus on ﬂows within
a period (say a year), assuming they all occur at the end of the period. We
assume this to reduce the number of things we have to keep track of. Whetheror not this assumption matters depends on: (1) the difference between the

actual time of cash ﬂow and whether we assume it ﬂows at the end of the
period (that is, a ﬂow on January 2 is 364 days from December 31, but a ﬂowon December 30 is only one day from December 31), and (2) the opportunity
cost of funds. Also, assuming that cash ﬂows occur at speciﬁc points in time
simpliﬁes the ﬁnancial mathematics we use in valuing these cash ﬂows.
CAPITAL BUDGETING TECHNIQUES

The estimation of the net cash ﬂows of a project is an important step inthe capital budgeting decision, but making a capital budgeting decision
requires analyzing these cash ﬂows to determine whether the project should
be undertaken.

EXHIBIT 13.4 Acme.com Cash Flow Analysis
Y e a r 0 1 2 3456789 1 0
Initial payment −$2,500,000
Sale of new 100,000 $30,000
Tax on sale of
new −40,000 −12,000
Change in
working
capital 20,000 −20,000
cash ﬂows −$2,420,000 −$2,000
Change in
r e v e n u e s $ 0 $ 0$ 0$ 0$ 0$ 0$ 0$ 0$ 0$ 0
Change in

Change in
expenses −400,000 −400,000 −400,000 −400,000 −400,000 −400,000 −400,000 −400,000 −400,000 −400,000
Change in
depreciation 500,000 800,000 480,000 288,000 288,000 144,000 $0 $0 $0 $0
Change in
taxableincome −$100,000 −$400,000 −$80,000 $112,000 $112,000 $256,000 $400,000 $400,000 $400,000 $400,000
Change in
taxes −40,000
−160,000 −32,000 44,800 44,800 102,400 160,000 160,000 160,000 160,000
Change in

Change in
after-taxincome −$60,000 −$240,000 −$48,000 $67,200 $67,200 $153,600 $240,000 $240,000 $240,000 $240,000
Change in
depreciation 500,000
800,000 480,000 288,000 288,000 144,000 0 0 0 0
Change in
operatingcash ﬂows $440,000
$560,000 $432,000 $355,200 $355,200 $297,600 $240,000 $240,000 $240,000 $240,000
Net cash ﬂow −$2,420,000 $440,000 $560,000 $432,000 $355,200 $355,200 $297,600 $240,000 $240,000 $240,000 $238,000
322

Capital Budgeting 323
The value of a company today is the present value of all its future cash
ﬂows. These future cash ﬂows come from assets that are already in place and
from future investment opportunities. The value of the company today is the
present value of these future cash ﬂows, discounted at a rate that represents

investors’ assessments of the uncertainty that they will ﬂow in the amountsand when expected.
The degree of uncertainty, or risk, of a project is reﬂected in the project’s
cost of capital. The cost of capital is what the company must pay for thefunds to ﬁnance its investment.
Given estimates of incremental cash ﬂows for a project and given a cost

of capital that reﬂects the project’s risk, we look at alternative techniquesthat are used to select projects. For now all we need to understand about a
project’s risk is that we can incorporate risk in either of two ways: (1) we
can discount future cash ﬂows using a higher discount rate, the greater the
cash ﬂow’s risk, or (2) we can require a higher annual return on a project,
the greater the risk of its cash ﬂows.
Evaluation Techniques

We look at six techniques that are commonly used by companies to evalu-ating investments in long-term assets:
1.Payback period
2.Discounted payback period
3.Net present value
4.Proﬁtability index
5.Internal rate of return
6.Modiﬁed internal rate of return
We are interested in how well each technique discriminates among the
different projects, steering us toward the projects that maximize owners’
wealth. An evaluation technique should:

■Consider all the future incremental cash ﬂows from the project
■Consider the time value of money
■Consider the uncertainty associated with future cash ﬂows
■Have an objective criterion by which to select a project
Projects selected using a technique that satisﬁes all four criteria will,
under most general conditions, maximize owners’ wealth.

324 VALUATION AND ANALYSIS TOOLS
EXHIBIT 13.5 Estimated Cash Flows for
Project One and Project Two
E n do fP e r i o dC a s hF l o w s
Year Project One Project Two
20X1 −$100,000 −$100,000
20X2 $0 $30,000
20X3 $0 $30,000
20X4 $0 $30,000
20X5 $140,000 $30,000
In addition to judging whether each technique satisﬁes these criteria, we

will also look at which ones can be used in special situations, such as when
a dollar limit is placed on the capital budget.
We use two projects, Project One and Project Two, to illustrate the
techniques. We show the cash ﬂows related to each project in Exhibit 13.5.Can you tell by looking at the cash ﬂows for Project One whether or not
it enhances wealth? Or, can you tell by just looking at Projects One and

Two which one is better? Perhaps with some projects you may think youcan pick out which one is better simply by gut feeling or eyeballing the cash
ﬂows. But why do it that way when there are precise methods to evaluate
investments by their cash ﬂows?
Payback Period
Thepayback period for a project is the time from the initial cash outﬂow
to invest in it until the time when its cash inﬂows add up to the initialcash outﬂow. In other words, how long it takes to get your money back.

The payback period is also referred to as the payoff period or the capital
recovery period. If you invest $10,000 today and are promised $5,000 one
year from today and $5,000 two years from today, the payback period istwo years—it takes two years to get your $10,000 back.
How long does it take to get your $100,000 from Project One back?
The payback period for Project One is four years:
Year Project One Cash Flows Accumulated Project One Cash Flows
20X2 $0 −$100,000

20X3 $0 −$100,000
20X4 $0 −$100,000
20X5 $130,000 $30,000

Capital Budgeting 325
By the end of 20X4, the full $100,000 is not paid back, but by 20X5,
the accumulated cash ﬂow is positive. Therefore, the payback period for
Project One is four years.
The payback period for Project Two is also four years. It is not until the

end of 20X5 that the $100,000 original investment (and more) is paid back:At the end of the third year, 20X4, all but $10,000 is paid back, but at the
end of 20X5, the entire $100,000 is paid back.
We have assumed that the cash ﬂows are received at the end of the
year. So we always arrive at a payback period in terms of a whole numberof years. If we assume that the cash ﬂows are received, say, uniformly,

such as monthly or weekly, throughout the year, we arrive at a paybackperiod in terms of years and fractions of years. If the company receives
cash ﬂows uniformly throughout the year, the payback period for Project
Two is 3
2/3years. Our assumption of end-of-period cash ﬂows may be

unrealistic, but it is convenient to use this assumption to demonstrate howto use the various evaluation techniques. Using this assumption, the paybackfor both Project One and Project Two is four years. We will continue to use
this end-of-period assumption throughout the coverage of capital budgeting
techniques.
Is Project One or Two more attractive? A shorter payback period is

better than a longer payback period. Yet there is no clear-cut rule for howshort is better. If we assume that all cash ﬂows occur at the end of the year,Project One provides the same payback as Project Two. Therefore, we do
not know in this particular case whether quicker is better.
In addition to having no well-deﬁned decision criteria, payback period

analysis favors investments with “front-loaded” cash ﬂows: an investmentlooks better in terms of the payback period the sooner its cash ﬂows are re-
ceived no matter what its later cash ﬂows look like. Payback period analysisis a type of “break-even” measure. It tends to provide a measure of the eco-
nomic life of the investment in terms of its payback period. The more likely
the life exceeds the payback period, the more attractive the investment. The

economic life beyond the payback period is referred to as the post-payback
duration. If post-payback duration is zero, the investment is worthless, no
matter how short the payback. This is because the sum of the future cash
ﬂows is no greater than the initial investment outlay. And since these future
cash ﬂows are really worth less today than in the future, a zero post-paybackduration means that the present value of the future cash ﬂows is less than
the project’s initial investment.

The payback method should only be used as a coarse initial screen of
investment projects. But it can be a useful indicator of some things. Becausea dollar of cash ﬂow in the early years is worth more than a dollar of cash
ﬂow in later years, the payback period method provides a simple, yet crudemeasure of the liquidity of the investment.

326 VALUATION AND ANALYSIS TOOLS
The payback period also offers some indication on the risk of the
investment. In industries where equipment becomes obsolete rapidly or
where there are very competitive conditions, investments with earlier pay-
back are more valuable. That’s because cash ﬂows farther into the future

are more uncertain and therefore have lower present value. In the per-sonal computer industry, for example, the ﬁerce competition and rapidly
changing technology requires investment in projects that have a payback of
less than one year since there is no expectation of project beneﬁts beyondone year.
Because the payback method doesn’t tell us the particular payback pe-
riod that maximizes wealth, we cannot use it as the primary decision toolfor the investment in long-lived assets.

Discounted Payback Period
Thediscounted payback period is the time needed to pay back the original
investment in terms of discounted future cash ﬂows. Therefore, we mustdiscount each cash ﬂow to the beginning of the project; the discountedpayback period is the length of time it takes these accumulated cash ﬂows
to become positive.
Each cash ﬂow is discounted back to the beginning of project at a

rate that reﬂects both the time value of money and the uncertainty of thefuture cash ﬂows. This rate is the cost of capital—the return required by the
suppliers of capital (creditors and owners) to compensate them for time value
of money and the risk associated with the investment. The more uncertain
the future cash ﬂows, the greater the cost of capital.
We discount an uncertain future cash ﬂow to the present at some rate

that reﬂects the degree of uncertainty associated with this future cash ﬂow.The more uncertain, the less the cash ﬂow is worth today—this means that ahigher discount rate is used to translate it into a value today. This discount
rate is a rate that reﬂects the opportunity cost of funds. We refer to this
opportunity cost as the cost of capital.
We don’t want to do anything that doesn’t create more than adollar’s worth of value for every dollar expended. And we’ll do the
best we can.

—Warren Buffett, Presentation to the Wharton School, 2008
Returning to Project One and Project Two, suppose that each has a cost
of capital of 5%. The ﬁrst step in determining the discounted payback periodis to discount each year’s cash ﬂow to the beginning of the investment (the
end of the year 20X1) at the cost of capital:

Capital Budgeting 327
Project One
Year Cash Flows Discounted Cash FlowsAccumulated
Discounted Cash Flows
20X1 −$100,000 −$100,000 −$100,000
20X2 $0 $0 −$100,000
20X3 $0 $0 −$100,000
20X4 $0 $0 −$100,000
20X5 $130,000 $106,951 $6,951
Project Two
20X2 $30,000 $28,571 −$71,429

20X3 $30,000 $27,211 −$44,218
20X4 $30,000 $25,915 −$18,303
20X5 $30,000 $24,681 $6,379
How long does it take for each investment’s discounted cash ﬂows to
pay back its $100,000 investment? The discounted payback period for both
Projects One and Two is four years.
It appears that the shorter the payback period, the better, whether

using discounted or non discounted cash ﬂows. But how short is better?We don’t know. All we know is that an investment “breaks-even” in terms
of discounted cash ﬂows at the discounted payback period—the point in
time when the accumulated discounted cash ﬂows equal the amount of the
If a project never pays back in terms of the discounted payback pe-

riod, we know that this project is not acceptable. Using the length of thediscounted payback as a basis for selecting investments that do payback,in terms of discounted cash ﬂow, we cannot distinguish Projects One and
Two. Both have a discounted payback period of four years. But we’ve ig-
nored some valuable cash ﬂows for both investments, those beyond what isnecessary for recovering the initial cash outﬂow.
Net Present Value

If offered an investment that costs $1,000 today and promises to pay you
$1,200 two years from today, and if your opportunity cost for projects of
similar risk is 5%, would you make this investment? To determine whether

328 VALUATION AND ANALYSIS TOOLS
or not this is a good investment you need to compare your $1,000 investment
with the $1,200 cash ﬂow you expect in two years. Because you determinethat a discount rate of 5% reﬂects the degree of uncertainty associated with
the $1,200 expected in two years, today it is worth:
Present value of $1,200 to be received in 2 years =$1,200
(1+0.05)2
=$1,088.44

(1+0.05)2
By investing $1,000, today you are getting in return, a promise of a cash
ﬂow in the future that is worth $1,088.44 today. You increase your wealth
by $88.44, which we refer to as the net present value.
Thenet present value (NPV ) is the present value of all expected cash

ﬂows. The word “net” in this term indicates that we consider all cash ﬂows—both positive and negative. We can represent the net present value usingsummation notation, where tindicates any particular period, CF
trepresents
the cash ﬂow at the end of period t,irepresents the cost of capital, and N
the number of periods comprising the economic life of the investment:
NPV=N∑
t=0CFt
(1+i)t(13.1)
Cash inﬂows are positive values of CFtand cash outﬂows are negative

values of CFt. For any given period t, we collect all the cash ﬂows (positive
and negative) and net them together. To make things a bit easier to track,let’s just refer to cash ﬂows as inﬂows or outﬂows, and not speciﬁcallyidentify them as operating or investment cash ﬂows.
Take another look at Projects One and Two. Using a 5% cost of capital,
the net present values are $6,951 and $6,379, respectively:
Year Cash Flows Discounted Cash Flows
20X2 $0 0

20X2 $0 0
20X3 $0 0
20X4 $0 0
20X5 $130,000 106,951
Net present value = $6,951

Capital Budgeting 329
20X2 $30,000 28,571
20X3 $30,000 27,211
20X4 $30,000 25,915
20X5 $30,000 24,681
Net present value = $6,379
These values should look familiar because we used these discounted
cash ﬂows in the discounted payback period. The NPV for Project One

indicates that if we invest in this project, we expect to increase the value
of the company by $6,951. Calculated in a similar manner, the net presentvalue of Project Two is $6,379.
We can use a ﬁnancial calculator to solve for the NPV, keying in the
cash ﬂows in order. We can also use Microsoft Excel’s NPV function to
solve for the net present value:
Microsoft Excel HP10B TI-83/84 
{0,0,0,130000}
STO listname
NPV(5,–100000, listname)100000+/–
CF j
0 CF j
0 CF j
0 CF j
130000CF j
5 i/YRNPVAB

CF j
0 CF j
0 CF j
0 CF j
130000CF j
1 Year Project One
2 20X1 –$100,0003 20X2 $0
4 20X3 $0
5 20X4 $0
6 20X5 $130,000
=NPV(.1,B3:B6)+B2
Net Present Value Decision Rule A positive net present value means that
the investment increases the value of the company—the return is more than
sufﬁcient to compensate for the required return of the investment. Another
way of stating this is that a project that has a positive net present value is
proﬁtable in an economic sense.1

1This does not mean, however, that the project is proﬁtable in terms of ﬁnancial
accounting.

330 VALUATION AND ANALYSIS TOOLS
A negative net present value means that the investment decreases the
value of the company—the return is less than the cost of capital. A zero
net present value means that the return just equals the return required by
owners to compensate them for the degree of uncertainty of the investment’s
future cash ﬂows and the time value of money. Therefore,

If...this means that the investment
is expected ... and you should ...
NPV>$0 to increase shareholder wealth accept the project.
NPV<$0 to decrease shareholder wealth reject the project.
NPV=$0 not to change shareholder wealth be indifferent between
accepting or rejecting
the project.
Project One is expected to increase the value of the company by $6,951,
whereas Project Two is expected to add $6,379 in value. If these are in-

dependent investments, both should be taken on because both increase the
value of the company. If Projects One and Two are mutually exclusive, suchthat the only choice is either One or Two, Project One is preferred since it
has the greater NPV.
The Investment Profile We may want to see how sensitive is our decision
to accept a project to changes in our cost of capital. We can see this sensitivity
in how a project’s net present value changes as the discount rate changes by

looking at a project’s investment proﬁle, also referred to as the net present
value proﬁle. The investment proﬁle is a graphical depiction of the relation
between the net present value of a project and the discount rate: the proﬁle
shows the net present value of a project for each discount rate, within
some range.
We provide the net present value proﬁle for the two projects in

Exhibit 13.6 for discount rates from 0% to 20%. The NPV for ProjectOne is positive for discount rates from 0% to 6.779%, and negative for
discount rates higher than 6.779%. The 6.779% is the internal rate of re-
turn; that is, the discount rate at which the net present value is equal to$0. Therefore, Project One increases owners’ wealth if the cost of capital on
this project is less than 6.779%, and decreases owners’ wealth if the cost of
capital on this project is greater than 6.779%.

If the discount rate is less than 5.361%, Project One adds more value
than Project Two, but if the discount rate is more than 5.361% but less

Capital Budgeting 331
$40,000
$30,000
$20,000
$10,000
$0NPV
Required Rate of Return–$10,000
–$20,000–$30,000
–$40,000
–$50,0000% 2% 4% 6% 8%6.779%
5.361%7.714%Project One
10% 12% 14% 16% 18% 20%
EXHIBIT 13.6 The Investment Proﬁles of Projects One and Two
than 7.714%, Project Two increases wealth more than Project One. If the

discount rate is greater than 7.714%, we should invest in neither project
because both would decrease wealth. The 5.361% is the cross-over discount
ratewhich produces identical NPVs for the two projects. If the discount rate
is 5.361%, the net present value of both investments is $5,492.
Solving for the Cross-Over Rate For Projects One and Two, the cross-
over rate is the rate that causes the net present value of the two investments

to be equal. Basically, this boils down to a simple approach: calculate thedifferences in the cash ﬂows and then solve for the internal rate of return of
these differences.
Year Project One Project Two Difference
20X1 −$100,000 −$100,000 $0
20X2 $0 $30,000 −$30,000
20X3 $0 $30,000 −$30,000
20X4 $0 $30,000 −$30,000
20X5 $130,000 $30,000 $100,000
The internal rate of return of these differences is the cross-over rate,
or 5.361%. Does it matter which project’s cash ﬂows you deduct from the

332 VALUATION AND ANALYSIS TOOLS
other? Not at all—just be consistent each period. Using a ﬁnancial calculator
or spreadsheet program:
TI-83/84 HP10B Microsoft Excel
{–30000, –30000,
–30000,100000} STO
listname
IRR(0,listname)0CF j
30000+/–/nobreakspaceCF j
100000CF j
IRRAB
1 Year Project Two
2 20X1 $0
3 20X2 $30,000
4 20X3 $30,000

2 20X1 $0
5 20X4 $30,0006 20X5 $100,000
Profitability Index
Theproﬁtability index uses some of the same information we used for the
net present value, but it is stated in terms of an index. Whereas the net
present value is:
NPV=N∑
t=0CFt
(1+i)t
The proﬁtability index, PI,i s :
PI=N∑
t=0CIF t
(1+i)t
COF t
(1+i)t(13.2)
where CIF and COF are cash inﬂows and cash outﬂows, respectively.
For Project One, the proﬁtability index is:

PIProject One =$106,951
$100,000=1.06951
The index value is greater than one, which means that the investment
produces more in terms of beneﬁts than costs. The decision rule for the
proﬁtability index is therefore depends on the PI relative to 1.0:

Capital Budgeting 333
is expected to ... and you should ...
PI>1.0 increase shareholder wealth accept the project.
PI<1.0 decrease shareholder wealth reject the project.
PI=1.0 not to change shareholder wealth be indifferent between
accepting or rejectingthe project.
The proﬁtability index for Project Two is 1.06379. Therefore, both

projects are acceptable according to the proﬁtability index criteria.
There is no direct solution for PI on your calculator; what you need to
do is calculate the present value of all the cash inﬂows and then divide thisvalue by the present value of the cash outﬂows. In the case of Project One,there is only one cash out ﬂow and it is already in present value terms (i.e.,
it occurs at the end of 20X1).
TRY IT! NPV AND PI
Consider a project that requires a $10,000 cash outlay and provides

$5,000 after one year and $7,000 after three years. If the cost of capital
of this project is 10%, what is the net present value and proﬁtability
of this project?
Internal Rate of Return
Suppose you are offered an investment opportunity that requires you to put
up $1,000 and has an expected cash inﬂow of $1,200 after two years. The
return on this investment is the discount rate that causes the present valuesof the $1,200 cash inﬂow to equal the present value of the $1,000 cash
outﬂow:

outﬂow:
$1,000 =$1,200
(1+IRR)2
Another way to look at this is to consider the investment’s cash ﬂows
discounted at a rate of 5%. The NPV of this project if the discount rate is5% (the IRR in this example), is positive, $88.44. Therefore, we know that
the rate that causes the NPV to be zero is greater than 5%. If we apply a

334 VALUATION AND ANALYSIS TOOLS
10% discount rate, the NPV is −$8.26. Therefore, we know that the IRR is
between 5% and 10%, and closer to 10%.
An investment’s internal rate of return (IRR) is the discount rate that
makes the present value of all expected future cash ﬂows equal to zero. We
can represent the IRR as the rate that solves:
$0=N∑
t=0CFt
(1+IRR)t (13.3)

$0=N∑
t=0CFt
The IRR for the investment of $1,000 that produces $1,200 two years
later is 9.545%.
Returning once again to Projects One and Two, the IRR of Project One
is 6.951% and the IRR of Project Two is 7.714%. As you may recall from
our discussion of the investment proﬁles, these are the discount rates at
which each project crosses the horizontal axis (i.e., NPV =$0).
We can use a ﬁnancial calculator or a spreadsheet program to solve for

the IRR. For example, for Project One,
STO listname–100000+/–
CFj
0 CF j
0 CF j
0 CF j
130000CF j
IRRA B
1Y ear Project One
220X1 –$100,000
320X2 $0
420X3 $0
520X4 $0
620X5 $130,000
=IRR(B2:B6)IRR(–100000,listname)
The internal rate of return is a yield—what we earn, on average, per
year. How do we use it to decide which investment, if any, to choose? Let’s
revisit Investments A and B and the IRRs we just calculated for each. If, for

similar risk investments, owners earn 10% per year, then both A and B areattractive. They both yield more than the rate owners require for the level
of risk of these two investments:
Project IRR Required Rate of Return
One 6.779% 5%
Two 7.714% 5%

Capital Budgeting 335
The decision rule for the internal rate of return is to invest in a project
if it provides a return greater than the cost of capital. The cost of capi-
tal, in the context of the IRR, is a hurdle rate—the minimum acceptable
rate of return. For independent projects and situations in which there

is no capital rationing, we compare the IRR with the required rate ofreturn, RRR:
IRR>RRR increase shareholder wealth accept the project.
IRR<RRR decrease shareholder wealth reject the project.
IRR=RRR not change shareholder wealth be indifferent between
What if we were forced to choose between Projects One and Two be-

cause they are mutually exclusive? Project Two has a higher IRR than ProjectOne—so at ﬁrst glance we might want to accept Project Two. What aboutthe NPV of One and Two? What does the NPV tell us to do? If we choose
on the basis of the higher IRR, we go with Project Two. If we choose the
project with the higher NPV when the cost of capital is 5%, we go withProject One. Which is correct? Choosing the project with the higher net

present value is consistent with maximizing owners’ wealth. Why? Because
if the cost of capital is 5%, we would calculate different NPVs and cometo a different conclusion, as you can see from the investment proﬁles in
Exhibit 13.6.
When evaluating mutually exclusive projects, the one with the highest
IRR may not be the one with the best NPV. The IRR may give a different
decision than NPV when evaluating mutually exclusive projects because ofthe built-in assumptions with these methods:

■NPV assumes cash ﬂows reinvested at the cost of capital.
■IRR assumes cash ﬂows reinvested at the internal rate of return.
These assumptions may cause different decisions in choosing among
mutually exclusive projects when:
■the timing of the cash ﬂows is different among the projects,
■there are scale differences (that is, very different cash ﬂow amounts), or
■the projects have different useful lives.

336 VALUATION AND ANALYSIS TOOLS
THE TROUBLE WITH IRR
“How large is the potential impact of a ﬂawed reinvestment-rate as-
sumption? Managers at one large industrial company approved 23
major capital projects over ﬁve years on the basis of IRRs that aver-
aged 77%. Recently, however, when we conducted an analysis withthe reinvestment rate adjusted to the company’s cost of capital, the

true average return fell to just 16%. The order of the most attrac-
tive projects also changed considerably. The top-ranked project basedon IRR dropped to the tenth-most-attractive project. Most striking,
the company’s highest-rated projects—showing IRRs of 800, 150, and
130%—dropped to just 15, 23, and 22%, respectively, once a realis-tic reinvestment rate was considered. Unfortunately, these investment
decisions had already been made.”

The McKinsey Quarterly , McKinsey & Co., October 20, 2004.
With respect to the role of the timing of cash ﬂows in choosing between
two projects: Project Two’s cash ﬂows are received sooner than Project
One’s. Part of the return on either is from the reinvestment of its cash
inﬂows. And, in the case of Project Two, there is more return from the

reinvestment of cash inﬂows. The question is “What do you do with thecash inﬂows when you get them?” We generally assume that if you receive
cash inﬂows, you’ll reinvest those cash ﬂows in other assets.
With respect to the reinvestment rate assumption in choosing between
these projects, suppose we can reasonably expect to earn only the cost ofcapital on our investments. Then for projects with an IRR above the cost of
capital we would be overstating the return on the investment using the IRR.

The bottom line? If we evaluate projects on the basis of their IRR, we
may select one that does not maximize value.
With respect to the NPV method: if the best we can do is reinvest cash
ﬂows at the cost of capital, the NPV assumes the more reasonable rate (thecost of capital). If the reinvestment rate is assumed to be the project’s costof capital, we would evaluate projects on the basis of the NPV and select
the one that maximizes owners’ wealth.

But what if there is capital rationing? Suppose Projects One and Two are
independent projects . Projects are independent if that the acceptance of one
does not prevent the acceptance of the other. And suppose the capital budget
is limited to $100,000. We are therefore forced to choose between Projects

Capital Budgeting 337
One and Two. If we select the one with the highest IRR, we choose Project
Two. But Two is expected to increase wealth less than Project One. Rankingand selecting investments on the basis of their IRRs may not maximize
wealth.
The source of the problem in the case of capital rationing is that the IRR

is a percentage, not a dollar amount. Because of this, we cannot determinehow to distribute the capital budget to maximize wealth because the invest-
ment or group of investments producing the highest yield does not meanthey are the ones that produce the greatest wealth.
The typical project usually involves only one large negative cash ﬂow
initially, followed by a series of future positive ﬂows. But that’s not alwaysthe case. Suppose you are involved in a project that uses environmentally

sensitive chemicals. It may cost you a great deal to dispose of them. And
that will mean a negative cash ﬂow at the end of the project.
Suppose we are considering a project that has cash ﬂows as follows:
Period End of Period Cash Flow
0 −$1,010
1 +2,400
2 −1,400
What is this project’s IRR? One possible solution is IRR =2.85%, yet
another possible solution is IRR =34.78%, as we show in Exhibit 13.7.
Remember that the IRR is the discount rate that causes the NPV to

be zero. In terms of this graph, this means that the IRR is the discountrate where the NPV is $0, the point at which the present value changes
sign—from positive to negative or from negative to positive.
$30
$20
$10
$0NPV
Internal rate of return–$10
–$20
–$30
–$40
0% 4% 8% 12% 16% 20% 24% 28% 32% 36% 40% 44% 48%
EXHIBIT 13.7 The Case of Multiple IRRs

338 VALUATION AND ANALYSIS TOOLS
TRY IT! IRR
Consider a project that requires a $1,000 outlay and provides $1,000
in one year and $200 in two years. What is the IRR of this project?
Modified Internal Rate of Return

When we use the internal rate of return method, we are assuming thatany cash inﬂows are reinvested at the investment’s internal rate of return.Consider Project One. The IRR is 10.17188%. If we take each of the cash
inﬂows from Project Two and reinvest them at 5%, we will have $129,304
at the end of 20X5:
Year Project Two Cash Flows Future Value of Cash Inﬂows
20X1 −$100,000
20X2 $30,000 $34,729
20X3 $30,000 33,075
20X4 $30,000 31,500
20X5 $30,000 30,000

Terminal value $129,304
The $129,304 is the project’s terminal value.2The terminal value is how
much the company has from this investment if all proceeds are reinvested
at the IRR. When the terminal value is used, the return calculated is themodiﬁed internal rate of return (MIRR). The MIRR for Project Two using
the terminal value as the future value we have:
FV=$129,304
PV=$100,000
N=4 years
MIRR =
4√
$129,304
$100,000−1=6.636%

N=4 years
MIRR =
4√
$129,304
2For example, the 2008 cash ﬂow of $200,000 is reinvested at 10.17188% for two
periods (that is, for 2009 and 2010), or $200,000 (1 +0.1017188)2=$242,756.88.

Capital Budgeting 339
In other words, by investing $1,000,000 at the end of 20X1 and receiv-
ing $129,304 produces an average annual return of 6.636%, which is the
project’s internal rate of return.
The MIRR is the return on the project assuming reinvestment of the
cash ﬂows at a speciﬁed rate. Consider Project One if the reinvestment rateis 6%:

Terminal value $131,238
If the reinvestment rate is 6%, the MIRR is 7.032%: If we, instead, rein-
vest Project Two’s cash ﬂows at Project Two’s IRR, 7.714%, we calculate
the MIRR to be 7.714%.
The MIRR is therefore a function of both the reinvestment rate and the
pattern of cash ﬂows, with higher the reinvestment rates leading to greaterMIRRs:

MIRR >RRR return more than required accept the project.
MIRR <RRR return less than required reject the project.
MIRR =RRR return what is required be indifferent between
You can see this in Exhibit 13.8, where the MIRRs of both Project One
and Project Two are plotted for different reinvestment rates. Project Two’s

MIRR is sensitive to the reinvestment rate; Project One’s MIRR is the same as
its IRR because it has a single cash inﬂow at the end of the life of the project.
Issues to Consider
Scale differences—differences in the amount of the cash ﬂows—betweenprojects can lead to conﬂicting investment decisions among the discountedcash ﬂow techniques. Consider two projects, Project Big and Project Lit-
tle. Each has a required rate of return of 5% per year with the following
cash ﬂows:

340 VALUATION AND ANALYSIS TOOLS
12%
12% 14%10%
10%8%
8%6%
6%4%
4%2%
2%0%
0%MIRR
Reinvestment Rate
EXHIBIT 13.8 MIRRs for Project One and Project Two
End of Period Project Big Cash Flows Project Little Cash Flows
0 $1,000,000 $1.00
1 +400,000 +0.40
2 +400,000 +0.40
3 +400,000 +0.50
Applying the discounted cash ﬂow techniques to each project, and as-

suming reinvestment at the required rate of return for the MIRR, we see
that selecting the project with the higher proﬁtability index, internal rate ofreturn, or modiﬁed internal rate of return will result in selecting the project
that adds the least value:
Technique Project Big Project Little
NPV $89,299 $0.1757
PI 1.0893 1.1757
IRR 9.7010% 13.7789%
MIRR 8.0368% 10.8203%
We already have seen that when selecting between mutually exclusive

projects, we should use the NPV instead of the IRR. Now, considering scale
differences, we add another precaution: When selecting among projects ofdifferent scales, the proﬁtability index and the modiﬁed internal rate of
return may lead to an incorrect decision.
Suppose a company is subject to capital rationing—say a limit of
$1,000,000—and Big and Little are independent projects. Which projectshould the company choose? The company can only choose one—spend

$1 or $1,000,000, but not $1,000,001. If you go strictly by the PI, IRR, orMIRR criteria, the company would choose Project Little. But is this the better

Capital Budgeting 341
project? Again, the techniques that ignore the scale of the investment—PI,
IRR, and MIRR—may lead to an incorrect decision.
Comparing Techniques
If we are dealing with mutually exclusive projects, the NPV method leadsus to invest in projects that maximize wealth, that is, capital budgetingdecisions consistent with owners’ wealth maximization. If we are dealing

with a limit on the capital budget, the NPV and PI methods lead us to invest
in the set of projects that maximize wealth.
We summarize the advantages and disadvantages of each of the tech-
niques for evaluating investments in Exhibit 13.9. We see in this table thatthe discounted cash ﬂow techniques are preferred to the non discountedcash ﬂow techniques. The discounted cash ﬂow techniques—NPV, PI, IRR,
MIRR—are preferable since they consider (1) all cash ﬂows, (2) the time

value of money, and (3) the risk of future cash ﬂows. The discounted cashﬂow techniques are also useful because we can apply objective decision
criteria—criteria we can actually use that tells us when a project increases
wealth and when it does not.
We also see in this table that not all of the discounted cash ﬂow tech-
niques are right for every situation. There are questions we need to ask whenevaluating a project, and the answers determine the appropriate technique

is the one to use for that investment:
■Are the projects mutually exclusive or independent?
■Are the projects subject to capital rationing?
■Are the projects of the same risk?
■Are the projects of the same scale of investment?
Here are some simple rules:
1.If projects are independent and not subject to capital rationing, we can
evaluate them and determine the ones that maximize wealth based onany of the discounted cash ﬂow techniques.

2.If the projects are mutually exclusive, have the same investment out-lay, and have the same risk, we must use only the NPV or the MIRRtechniques to determine the projects that maximize wealth.
3.If projects are mutually exclusive and are of different risks or are ofdifferent scales, NPV is preferred over MIRR.
If the capital budget is limited, we can use either the NPV or the PI. We
must be careful, however, not to select projects on the basis of their NPV

(that is, ranking on NPV and selecting the highest NPV projects), but ratherhow we can maximize the NPV of the total capital budget.

342 VALUATION AND ANALYSIS TOOLS
EXHIBIT 13.9 Advantages and Disadvantages of the Capital
Budgeting Techniques
Advantages
1.Simple to compute.
2.Provides some information on the
risk of the investment.
3.Provides a crude measure of
liquidity.Disadvantages
1.No concrete decision criteria to
indicate whether an investment
increases the company’s value.

2.Ignores cash ﬂows beyond the
payback period, the time value of
money, and the risk of future cash
ﬂows.
Discounted Payback PeriodAdvantages
1.Considers the time value of money.
2.Considers the project’s cash ﬂows’
risk through the cost of capital.Disadvantages
1.No concrete decision criteria that
indicate whether the investment
2.Requires an estimate of the cost ofcapital in order to calculate the
payback.

payback.
3.Ignores cash ﬂows beyond the
discounted payback period.
1.Indicates whether the investment is
expected to increase the company’svalue.
2.Considers all the cash ﬂows, thetime value of money, and the riskof future cash ﬂows.Disadvantages
1.Requires an estimate of the cost of
capital in order to calculate the netpresent value.
2.Expressed in terms of dollars.
Proﬁtability IndexAdvantages
1.Tells whether an investment

2.Considers all cash ﬂows of theproject, the time value of money,
and future cash ﬂows’ risk.
3.Useful in ranking and selecting
projects when capital is rationed.Disadvantages
capital in order to calculate the
proﬁtability index.
2.May not give the correct decisionwhen used to compare mutuallyexclusive projects.

Capital Budgeting 343
EXHIBIT 13.9 (Continued )
2.Considers all cash ﬂows of the
project, the time value of money,
and future cash ﬂows’ risk.Disadvantages
1.Requires an estimate of the cost of capital
in order to make a decision.
2.May not give the value-maximizing

decision when used to compare mutually
exclusive projects.
3.May not give the value-maximizing
decision when used to choose projects
when there is capital rationing.
4.Cannot be used in situations in which the
sign of the cash ﬂows of a project change
more than once during the project’s life.
Modiﬁed Internal Rate of ReturnAdvantages
1.Indicates whether an investment
is expected to increase the
company’s value.

exclusive projects or when there is capital
rationing.
TRY IT! ACME.COM
Using the cash ﬂows of the Acme.com project that we provide in
Exhibit 13.4, calculate:
1.Payback period,
2.Discounted payback period,

3.Net present value,
4.Proﬁtability index,
5.Internal rate of return, and
6.Modiﬁed internal rate of return.
Assume a required rate of return of 6% and a reinvestment rate
of 6%.

344 VALUATION AND ANALYSIS TOOLS
■Capital budgeting involves allocating capital among long-lived invest-
ment projects. Capital budgeting requires estimating the incremental
cash ﬂows that the project is expected to generate, and then applying

techniques such as the net present value or the internal rate of returnto evaluate the cash ﬂows and determine whether the investment in the
project is consistent with maximizing owners’ wealth.
■The key to evaluating cash ﬂows is to identify how the company’s
cash ﬂows change if the investment is made. This requires estimat-
ing cash ﬂows pertaining to the acquisition and eventual disposal of the
capital project assets, as well as the change in the company’s operatingcash ﬂows.

■The methods available to evaluate a capital project include the paybackperiod, the discounted payback period, the net present value, the prof-
itability index, the internal rate of return, and the modiﬁed internal rate
of return.
■The preferred method of evaluating capital projects in the net present
value method, though in certain circumstances we would arrive at
the same decision using other methods, such as the internal rate ofreturn.

Disposition Cash Flows, Using Straight-Line
Book value (BV) at the time of sale =$500,000 ×(1−0.25−0.25)
=$250,000
Loss=$100,000 −250,000 =−$150,000
Tax beneﬁt =0.35×$150,000 =$52,500
CF=$100,000 +52,500 =$152,500
Disposition Cash Flows, Using MACRS
Book value (BV) at the time of sale =$500,000 ×(1−0.3333 −0.4445)
=$111,100
Loss=$100,000 −111,100 =−$11,000
Tax beneﬁt =0.35×$11,100 =$3,885
CF=$100,000 +3,885 =$103,885

Capital Budgeting 345
Change in Expenses
Cash ﬂow =−$50,000 +20,000 =−$30,000
NPV & PI
NPV=−$195.34
PI=0.9805
IRR
IRR=17.082%
Acme.com
Payback period 6 years
Discounted payback period 9 years
Net present value $197,928
Proﬁtability index 1.082
Internal rate of return 8.009%
Modiﬁed internal rate of return 6.8412%
QUESTIONS

QUESTIONS
1.If a project does not affect a company’s revenues, but reduces its costs,how can this affect the value of the company?
2.What is a depreciation tax shield, and how does this affect a capital
budgeting decision?
3.If a company is making an investment decision to use a facility that iscurrently idle, how does the cost of this facility enter into the decision?
4.If a capital project has a positive net present value, does it pay back in

terms of discounted cash ﬂows? Explain.
5.If a company sells an asset for less than its original cost, but more thanits book value, how is that gain classiﬁed and taxed?
6.If a company chooses to use straight-line depreciation instead of
MACRS depreciation for an asset, how does this decision affect the
proﬁtability of the project?
7.If a company is deciding between two projects, and can only select one
of the two projects, what evaluation techniques should this company

346 VALUATION AND ANALYSIS TOOLS
8.Suppose, when evaluating two mutually exclusive projects, the company
makes the value-maximizing decision to select the one with the lowerinternal rate of return. What does this tell you regarding the relation
between the discount rate and the cross-over rate?
9.When selecting capital projects and there is a limit to the capital budget,

which evaluation techniques are appropriate to use?
10.The net present value method and the internal rate of return method mayproduce different decisions when selecting among mutually exclusiveprojects. What is the source of this conﬂict?
11.Classify each of the following projects for a toy manufacturer into one ofthe three categories: replacement, new product or market, or mandated,by checking the appropriate box:
New Product
Replacement or Market Mandated
Opening a retail outlet □□ □

Introducing a new line of dolls □□ □
Introducing a new action ﬁgure in an
existing line of action ﬁgures□□ □
Adding pollution control equipment
to avoid environmental ﬁnes□□ □
Computerizing the doll molding
equipment□□ □
Introducing a child’s version of an
existing adult board game□□ □
12.A shoe manufacturer is considering introducing a new line of boots.When evaluating the incremental revenues from this new line, whatshould be considered?

13.The Pittsburgh Steel Company is considering two different wire solder-ing machines. Machine 1 has an initial cost of $100,000, costs $20,000to set up, and is expected to be sold for $20,000 after 10 years. Ma-
chine 2 has an initial cost of $80,000, costs $30,000 to set up, and is
expected to be sold for $10,000 after 10 years. Both machines would bedepreciated over 10 years using straight-line depreciation. The company
Pittsburgh has a tax rate of 35%.

a.What are the cash ﬂows related to the acquisition of each machine?
b.What are the cash ﬂows related to the disposition of each machine?

Capital Budgeting 347
14.The president of Fly-by-Night Airlines has asked you to evaluate the
proposed acquisition of a new jet. The jet’s price is $40 million, andit is classiﬁed in the 10-year MACRS class. The purchase of the jet
would require an increase in net working capital of $200,000. The jet

would increase the ﬁrm’s before-tax revenues by $20 million per year,but would also increase operating costs by $5 million per year. The jet
is expected to be used for three years and then sold for $25 million. The
ﬁrm’s marginal tax rate is 40%.a.What is the amount of the investment outlay required at the begin-
ning of the project?
b.What is the amount of the operating cash ﬂow each year?
c.What is the amount of the nonoperating cash ﬂow in the third year?

d.What is the amount of the net cash ﬂow for each year?
15.Suppose you calculate a project’s net present value to be $10 million.What does this mean?
16.Suppose you calculate a project’s proﬁtability index to be 1.3. What
does this mean?
17.Suppose you calculate a project’s net present value to be $30 million. Ifthe required outlay for this project is $100 million, what is the project’sproﬁtability index?
18.You are evaluating an investment project with the following cash ﬂows:
Period Cash Flow

0 −$100,000
1 35,000
2 35,000
3 35,000
4 35,000
Calculate the following:
a.Payback period
b.Discounted payback period, assuming a 10% cost of capital
c.Discounted payback period, assuming a 16% cost of capital
d.Net present value, assuming a 10% cost of capital
e.Net present value, assuming a 16% cost of capital
f.Proﬁtability index, assuming a 10% cost of capital
g.Proﬁtability index, assuming a 16% cost of capital
h.Internal rate of return

i.Modiﬁed internal rate of return, assuming reinvestment at 0%
j.Modiﬁed internal rate of return, assuming reinvestment at 10%

348 VALUATION AND ANALYSIS TOOLS
19.Suppose you are evaluating two mutually exclusive projects, Thing 1
and Thing 2, with the following cash ﬂows:
End-of-Year Cash Flows
Year Thing 1 Thing 2
0 −$10,000 −$10,000
1 3,293 0
2 3,293 0
3 3,293 0
4 3,293 14,641
a.If the cost of capital on both projects is 5%, which project, if any,
would you choose? Why?

b.If the cost of capital on both projects is 8%, which project, if any,
c.If the cost of capital on both projects is 11%, which project, if any,would you choose? Why?
d.If the cost of capital on both projects is 14%, which project, if any,
e.At what discount rate would you be indifferent when choosing be-
tween Thing 1 and Thing 2?

f.On the same graph, draw the investment proﬁles of Thing 1 andThing 2, indicating the following items:
■Cross-over discount rate
■NPV of Thing 1 if the cost of capital is 5%
■NPV of Thing 2 if the cost of capital is 5%
■IRR of Thing 1
■IRR of Thing 2

c14 JWBT310-Fabozzi July 8, 2010 13:15 Printer: Courier Westford, Westford, MA
CHAPTER14
Derivatives for Controlling Risk
SARBANES: “Warren Buffett has warned us that derivatives are
time bombs, both for the parties that deal in them and the
economic system. The Financial Times has said so far, there has
been no explosion, but the risks of this fast growing market
remain real. How do you respond to these concerns?”

BERNANKE: “I am more sanguine about derivatives than the
position you have just suggested. I think, generally speaking, theyare very valuable. They provide methods by which risks can be
shared, sliced, and diced, and given to those most willing to bear
them. They add, I believe, to the ﬂexibility of the ﬁnancial systemin many different ways. With respect to their safety, derivatives,
for the most part, are traded among very sophisticated ﬁnancial

institutions and individuals who have considerable incentive tounderstand them and to use them properly. The Federal Reserve’s
responsibility is to make sure that the institutions it regulates have
good systems and good procedures for ensuring that theirderivatives portfolios are well managed and do not create excessive
risk in their institutions.”
—Interchange between Senator Paul Sarbanes and Federal
Reserve Bank Chairman Ben Bernanke,
Senate Banking Committee hearing, November 2005

Derivative instruments play an important role in ﬁnancial markets as well
as commodity markets by allowing market participants to control their
exposure to different types of risk. In this chapter, we describe four types of
derivative contracts:
1.Futures,
2.Forwards,
349

350 VALUATION AND ANALYSIS TOOLS
3.Options, and
4.Swaps.
As we discuss these derivatives, you will likely begin to see the common
threads among them. First, these instruments derive their value from another
security or asset, which we refer to as the underlying asset , or simply as the
underlying . Second, the value of a derivative is dependent not only on the

value of the underlying, but also on the features of the derivative itself.
Derivatives are like prescription drugs. They can be beneﬁcial when
used appropriately, but they may be habit-forming and carry the
risk of unpleasant side effects.
—David Litvack, Risk, April 2006, p. 20
FUTURES AND FORWARD CONTRACTS
Futures and forward contracts are contracts between a buyer and a seller

for the future delivery, at a speciﬁed point in time, of a speciﬁed commodity,security, or other asset. Futures contracts are standardized agreements as to
the delivery date (or month) and quality of the deliverable, and are traded
on organized exchanges. A forward contract differs in that it is usually non-standardized (that is, the terms of each contract are negotiated individually
between buyer and seller). We will ﬁrst look at futures contracts, and then
focus on forward contracts.

Futures Contracts
Afutures contract is a legal agreement between a buyer and a seller in
which:
■The buyer agrees to take delivery of something at a speciﬁed price at theend of a designated period of time.
■The seller agrees to make delivery of something at a speciﬁed price atthe end of a designated period of time.
Of course, no one buys or sells anything when entering into a futures
contract. Rather, those who enter into a contract agree to buy or sell a

speciﬁc amount of a speciﬁc item at a speciﬁed future date. When we speak
of the “buyer” or the “seller” of a contract, we are simply adopting thejargon of the futures market, which refers to parties of the contract in terms
of the future obligation they are committed to.
Let’s look closely at the key elements of this contract. The price at which
the parties agree to transact in the future is the futures price. The designated

Derivatives for Controlling Risk 351
date at which the parties must transact is the settlement date ordelivery date.
The “something” that the parties agree to exchange is the underlying. We
refer to the party on the opposite side of the transaction as the counterparty .
Therefore, the buyer is the counterparty of the seller, and the seller is the
counterparty to the buyer.

To illustrate, suppose a futures contract is traded on an exchange where
the underlying to be bought or sold is asset XYZ, and the settlement is threemonths from now. Assume further that Bert buys this futures contract, and
Ernie sells this futures contract, and the price at which they agree to transactin the future is $100. Then $100 is the futures price. At the settlement
date, Ernie will deliver asset XYZ to Bert. Bert will give Ernie $100, the
futures price.

When an investor takes a position in the market by buying a futures
contract (or agreeing to buy at the future date), the investor is said to be in along position or to be long futures. If, instead, the investor’s opening position
is the sale of a futures contract (which means the contractual obligation to
sell something in the future), the investor is said to be in a short position or
short futures.
The buyer of a futures contract realizes a proﬁt if the futures price

increases; the seller of a futures contract realizes a proﬁt if the futures
price decreases. For example, suppose that one month after Bert and Ernie
take their positions in the futures contract, the futures price of asset XYZ
increases to $120. Bert, the buyer of the futures contract, could then sellthe futures contract and realize a proﬁt of $20. Effectively, at the settlement
date, he has agreed to buy asset XYZ for $100 and has agreed to sell asset

XYZ for $120. Ernie, the seller of the futures contract, will realize a lossof $20.
If the futures price falls to $40 and Ernie buys back the contract at $40,
he realizes a proﬁt of $60 because he agreed to sell asset XYZ for $100 andnow can buy it for $40. Bert would realize a loss of $60. Thus, if the futures
price decreases, the buyer of the futures contract realizes a loss while the
seller of the futures contract realizes a proﬁt:
Price of Underlying
at Settlement Is
$120Price of Underlying

$60
Bert Ernie Bert Ernie
Sell the underlying $120 $100 $60 $100Buy the underlying 100
120 100 60
Proﬁt or loss $20 −$20 −$40 $40

352 VALUATION AND ANALYSIS TOOLS
Liquidating a Position Most ﬁnancial futures contracts have settlement
dates in the months of March, June, September, or December. This means
that at a predetermined time in the settlement month, the contract stops
trading, and a price is determined by the exchange for settlement of the

contract. For example, on January 4, 200X, suppose Bert buys and Erniesells a futures contract that settles on the third Friday of March of 200X.
Then, on that date, Bert and Ernie must perform—Bert agreeing to buy
asset XYZ at $100, and Ernie agreeing to sell asset XYZ at $100. Theexchange will determine a settlement price for the futures contract for that
speciﬁc date. For example, if the exchange determines a settlement price of

$130, then Bert has agreed to buy asset XYZ for $100 but can settle theposition for $130, thereby realizing a proﬁt of $30. Ernie would realize a loss
of $30.
Instead of Bert or Ernie entering into a futures contract on January 4,
200X that settles in March, they could have selected a settlement in June,
September, or December. The contract with the closest settlement date iscalled the nearby futures contract. Thenext futures contract is the one that

settles just after the nearby contract. The contract farthest away in time fromsettlement is called the most distant futures contract.
A party to a futures contract has two choices regarding the liquidation
of the position. First, the position can be liquidated prior to the settlementdate. For this purpose, the party must take an offsetting position in thesame contract. For the buyer of a futures contract, this means selling the

same number of identical futures contracts; for the seller of a futures con-
tract, this means buying the same number of identical futures contracts.An identical contract means the contract for the same underlying and the
same settlement date. So, for example, if Bert buys one futures contract
for asset XYZ with settlement in March 200X on January 4, 200X, andwants to liquidate a position on February 14, 200X, he can sell one futures

contract for asset XYZ with settlement in March 200X. Similarly, if Ernie
sells one futures contract for asset XYZ with settlement in March 200X
on January 4, 200X, and wants to liquidate a position on February 22,
200X, he can buy one futures contract for asset XYZ with settlement inMarch 200X. A futures contract on asset XYZ that settles in June 200X
is not the same contract as a futures contract on asset XYZ that settles in
March 200X.

The alternative is to wait until the settlement date. At that time, the party
purchasing a futures contract accepts delivery of the underlying; the partythat sells a futures contract liquidates the position by delivering the under-lying at the agreed upon price. For some futures contracts that we shall
describe later in later chapters, settlement is made in cash only. Such con-
tracts are referred to as cash settlement contracts.

Derivatives for Controlling Risk 353
A useful statistic for measuring the liquidity of a contract is the number
of contracts that have been entered into but not yet liquidated. This ﬁgure
is called the contract’s open interest. An exchange reports an open interest
ﬁgure for every futures contracts traded on the exchange.
The Role of the Clearinghouse Associated with every futures exchange

is a clearinghouse, which performs several functions. One of these func-
tions is to guarantee that the two parties to the transaction will perform.
Because of the clearinghouse, the two parties need not worry about the ﬁ-nancial strength and integrity of the other party taking the opposite side
of the contract. After initial execution of an order, the relationship be-
tween the two parties ends. The clearinghouse interposes itself as the buyer

for every sale and as the seller for every purchase. Thus, the two par-
ties are then free to liquidate their positions without involving the otherparty in the original contract, and without worry that the other party may
default.
Margin Requirements When a position is ﬁrst taken in a futures contract,
the investor must deposit a minimum dollar amount per contract as speciﬁed
by the exchange. This amount, called initial margin, is required as a deposit

for the contract. The initial margin may be in the form of an interest-
bearing security, such as a U.S. Treasury bill. The initial margin is placed in
an account, and the amount in this account is referred to as the investor’s
equity. As the price of the futures contract ﬂuctuates each trading day, the
value of the investor’s equity in the position changes.
At the end of each trading day, the exchange determines the “settlement

price” for the futures contract. The settlement price is different from the
closing price, which is the price of the security in the ﬁnal trade of the day
(whenever that trade occurred during the day). By contrast, the settlement
price is that value the exchange considers to be representative of trading at
the end of the day. The exchange uses the settlement price to mark to market

the investor’s position, so that any gain or loss from the position is quicklyreﬂected in the investor’s equity account.
Amaintenance margin is the minimum level (speciﬁed by the exchange)
by which an investor’s equity position may fall as a result of unfavorableprice movements before the investor is required to deposit additional margin.
The maintenance margin requirement is a dollar amount that is less than the

initial margin requirement. It sets the ﬂoor that the investor’s equity accountcan fall to before the investor is required to furnish additional margin. The
additional margin deposited, called variation margin, is an amount necessary
to bring the equity in the account back to its initial margin level. Unlike initial

354 VALUATION AND ANALYSIS TOOLS
margin, variation margin must be in cash, not interest-bearing instruments.
Any excess margin in the account may be withdrawn by the investor. If aparty to a futures contract who is required to deposit a variation margin
fails to do so within 24 hours, the futures position is liquidated by the
clearinghouse.
1

1
Regarding the variation margin, we should note two things: First, the
variation margin must be cash. Second, the amount of variation marginrequired is the amount to bring the equity up to the initial margin, not themaintenance margin.
Leveraging When taking a position in a futures contract, a party need not
put up the entire amount of the investment. Instead, the exchange requires
that only the initial margin be invested. To see the crucial consequences of

this fact, suppose Bert has $100 and wants to invest in asset XYZ because
he believes its price will appreciate. If asset XYZ is selling for $100, he canbuy one unit of the asset in the cash market, the market where goods are
delivered upon purchase. His payoff will then be based on the price action
of one unit of asset XYZ.
Suppose that the exchange where the futures contract for asset XYZ is

traded requires an initial margin of only 5%, which in this case would be$5. Then Bert can purchase 20 contracts with his $100 investment. (Thisexample ignores the fact that Bert may need funds for variation margin.) His
payoff will then depend on the price action of 20 units of asset XYZ. Thus,
he can leverage the use of his funds. (The degree of leverage equals 1/margin
rate. In this case, the degree of leverage equals 1/0.05, or 20.) While the

degree of leverage available in the futures market varies from contract tocontract, as the initial margin requirement varies, the leverage attainable is
considerably greater than in the cash market.
At ﬁrst, the leverage available in the futures market may suggest that
the market beneﬁts only those who want to speculate on price movements.This is not true. As we shall see, futures markets can be used to reduce
1Although there are initial and maintenance margin requirements for buying se-

curities on margin, the concept of margin differs for securities and futures. When
securities are acquired on margin, the difference between the price of the security
and the initial margin is borrowed from the broker. The security purchased servesas collateral for the loan, and the investor pays interest. For futures contracts, the
initial margin, in effect, serves as “good-faith” money, an indication that the investor

will satisfy the obligation of the contract. Normally, no money is borrowed by the
investor.

Derivatives for Controlling Risk 355
price risk. Without the leverage possible in futures transactions, the cost
of reducing price risk using futures would be too high for many marketparticipants.
Forward Contracts
Aforward contract , just like a futures contract, is an agreement for the future

delivery of the underlying at a speciﬁed price at the end of a designated periodof time. Unlike futures, there is no clearinghouse, and secondary marketsare often nonexistent or extremely thin. A forward contract is an over-the-
counter instrument.
Because there is no clearinghouse that guarantees the performance of
a counterparty in a forward contract, the parties to a forward contract areexposed to counterparty risk, the risk that the other party to the transaction

will fail to perform. Futures contracts are marked to market at the end
of each trading day, while forward contracts usually are not. Consequently,
futures contracts are subject to interim cash ﬂows because additional margin
may be required in the case of adverse price movements or because cash may
be withdrawn in the case of favorable price movements. A forward contract

may or may not be marked to market. Where the counterparties are twohigh-credit-quality entities, the two parties may agree not to mark positions
to market. However, if one or both of the parties are concerned with the
counterparty risk of the other, then positions may be marked to market.Thus, when a forward contract is marked to market, there are interim cash
ﬂows just as with a futures contract. When a forward contract is not marked
to market, then there are no interim cash ﬂows.

Other than these differences, what we said about futures contracts ap-
plies to forward contracts too.
The Basics of Pricing Futures and Forward Contracts When using
derivatives, a market participant should understand the basic principles of
how they are valued. While there are many models that have been proposed

for valuing ﬁnancial instruments that trade in the cash (spot) market, the val-uation of all derivative models are based on arbitrage arguments. Basically,
this involves developing a strategy or a trade wherein a package consisting
of a position in the underlying (that is, the underlying asset or instrument forthe derivative contract) and borrowing or lending so as to generate the same
cash ﬂow proﬁle as the derivative. The value of the package is then equal

to the theoretical price of the derivative. If the market price of the deriva-tive deviates from the theoretical price, then the actions of arbitrageurs will

356 VALUATION AND ANALYSIS TOOLS
drive the market price of the derivative toward its theoretical price until the
arbitrage opportunity is eliminated.
In developing a strategy to capture any mispricing, certain assump-

tions are made. When these assumptions are not satisﬁed in the real world,the theoretical price can only be approximated. Moreover, a close exam-ination of the underlying assumptions necessary to derive the theoretical
price indicates how a pricing formula must be modiﬁed to value speciﬁc
contracts.
Here we describe how futures and forward are valued. The pricing

of futures and forward contracts is similar. If the underlying asset for bothcontracts is the same, the difference in pricing is due to differences in featuresof the contract that must be dealt with by the pricing model.
We illustrate the basic model for pricing futures contract. By “basic,”
we mean that we are extrapolating from the nuisances of the underlying
for a speciﬁc contract. The issues associated with applying the basic pricing

model to some of the more popular futures contracts are not described here.Moreover, while the model described here is said to be a model for pricing
futures, technically, it is a model for pricing forward contracts with no
mark-to-market requirements.
Rather than deriving the formula algebraically, we demonstrate the basic
pricing model using an example. We make the following six assumptionsfor a futures contract that has no initial and variation margin:

1.The price of Asset U in the cash market is $100.
2.There is a known cash ﬂow for Asset U over the life of the futurescontract.
3.The cash ﬂow for Asset U is $8 per year paid quarterly ($2 per quarter).
4.The next quarterly payment is exactly three months from now.
5.The futures contract requires delivery three months from now.
6.The current three-month interest rate at which funds can be lent orborrowed is 4% per year.
The objective is to determine what the futures price of this contract

should be. To do so, suppose that the futures price in the market is $105.
Let’s see if that is the correct price. We can check this by implementing the
following simple strategy:
■Sell the futures contract at $105.
■Purchase Asset U in the cash market for $100.
■Borrow $100 for three months at 4% per year ($1 per quarter).

Derivatives for Controlling Risk 357
The purchase of Asset U is accomplished with the borrowed funds.
Hence, this strategy does not involve any initial cash outlay. At the end of
three months, the following occurs:
■$2 is received from holding Asset U.
■Asset U is delivered to settle the futures contract.
■The loan is repaid.

This strategy results in the following outcome, indicating what happens
now and later (that is, three months from now):
Now Later
Action Cash Flow Action Cash Flow
Sell futures $0 Pay off loan −$100
Borrow $100 100 Interest on loan −1
Buy Asset U −100 Deliver Asset U 105
Receive payment 2
Cash ﬂow $0 Cash ﬂow $6
The proﬁt of $6 from this strategy is guaranteed regardless of what
the cash price of Asset U is three months from now. This is because in the

preceding analysis of the outcome of the strategy, the cash price of Asset Uthree months from now never enters the analysis. Moreover, this proﬁt is
generated with no investment outlay; the funds needed to acquire Asset U
are borrowed when the strategy is executed. In ﬁnancial terms, the proﬁt inthe strategy we have just illustrated arises from a riskless arbitrage between
the price of Asset U in the cash market and the price of Asset U in the
futures market.

In a well-functioning market, arbitrageurs who could realize this riskless
proﬁt for a zero investment would implement the strategy described above.By selling the futures and buying Asset U in order to implement the strategy,this would force the futures price down so that at some price for the futures
contract, the arbitrage proﬁt is eliminated.
This strategy that resulted in the capturing of the arbitrage proﬁt is

referred to as a cash-and-carry trade. The reason for this name is that im-
plementation of the strategy involves borrowing cash to purchase the un-
derlying and “carrying” that underlying to the settlement date of the futurescontract.

358 VALUATION AND ANALYSIS TOOLS
From the cash-and-carry trade we see that the futures price cannot be
$105. Suppose instead that the futures price is $95 rather than $105. Let’s try
the following strategy to see if that price can be sustained in the market:
■Buy the futures contract at $95.
■Sell (short) Asset U for $100.
■Invest (lend) $100 for three months at 1% per year.

We assume once again that in this strategy there is no initial margin
and variation margin for the futures contract. In addition, we assume that
there is no cost to selling the asset short and lending the money. Given these
assumptions, there is no initial cash outlay for the strategy just as with the
cash-and-carry trade.
This strategy produces the following now and later, at the end of three
months:
Now Later
Buy futures $0 Receive loan repayment $100

Lend $100 −100 Receive interest on loan 1
Sell Asset U +100 Buy Asset U to cover short sale −95
Make payment −2
Cash ﬂow $0 Cash ﬂow $4
As with the cash-and-carry trade, the $4 proﬁt from this strategy is a
riskless arbitrage proﬁt. This strategy requires no initial cash outlay, but will
generate a proﬁt whatever the price of Asset U is in the cash market at the
settlement date. In real-world markets, this opportunity would lead arbi-

trageurs to buy the futures contract and short Asset U. The implementation
of this strategy would be to raise the futures price until the arbitrage proﬁtdisappeared.
This strategy to capture the arbitrage proﬁt is known as a reverse cash-
and-carry trade. That is, with this strategy, the underlying is sold short andthe proceeds received from the short sale are invested.
We can see that the futures price cannot be $95 or $105. What is the

theoretical futures price given the assumptions in our illustration? As weshow in Exhibit 14.1, if the futures price is $99 there is no opportunity for
an arbitrage proﬁt. That is, neither the cash-and-carry trade nor the reverse
cash-and-carry trade generates an arbitrage proﬁt.

Derivatives for Controlling Risk 359
EXHIBIT 14.1 Cash Flow When There Is a No-Arbitrage Futures Price
Cash and Carry Cash Flows if the Futures Price Is $99
Now Later
Buy Asset U −100 Deliver Asset U 99
Cash ﬂow $0 Cash ﬂow $0

Reverse Cash and Carry Cash Flow if the Futures Price Is $99
Now Later
Sell Asset U +100 Receive interest on loan 1
Lend $100 −100 Buy Asset U to cover short sale −99
In general, the formula for determining the theoretical price given the
assumptions of the model is:
Theoretical
futures price−Cash market
price+[Cash market

price×(Financing
cost−Cash
yield)]
(14.1)
In the formula given by equation (14.1), “Financing cost” is the interest
rate to borrow funds and “Cash yield” is the payment received from in-
vesting in the asset as a percentage of the cash price. In our illustration, the
ﬁnancing cost is 1% and the cash yield is 2%.
In our illustration, because the cash price of Asset U is $100, the theo-
retical futures price is:
$100+[$100 ×(1%−2%)] =$99

The future price can be above or below the cash price depending on the
difference between the ﬁnancing cost and cash yield. The difference between
these rates is the net ﬁnancing cost . A more commonly used term for the net

360 VALUATION AND ANALYSIS TOOLS
ﬁnancing cost is the cost of carry , or, simply, carry .Positive carry means
that the cash yield exceeds the ﬁnancing cost.2Negative carry means that
the ﬁnancing cost exceeds the cash yield. As a result,
Positive
carryFutures price < Cash price
Futures price > Cash priceFutures price = Cash priceNegative
carry
Zero
carry

carry
Zero
carry
Note that at the settlement date of the futures contract, the futures price
must equal the cash market price. The reason is that a futures contract
with no time left until delivery is equivalent to a cash market transaction.
Thus, as the delivery date approaches, the futures price converges to the cash
market price. This fact is evident from the formula for the theoretical futures

price given by equation (14.1). The ﬁnancing cost approaches zero as thedelivery date approaches. Similarly, the yield that can be earned by holding
the underlying approaches zero. Hence, the cost of carry approaches zero,
and the futures price approaches the cash market price.
TRY IT! FUTURES
Suppose you borrow $1,000 at 8% per year so that you can use this
money to buy Asset W. You also sell a futures contract on Asset W,
with delivery in one year.
1.What type of transaction is this?

2.Is this a proﬁtable transaction if the futures price is $1,010?
A Closer Look at the Theoretical Futures Price In deriving theoretical
futures price using the arbitrage argument, we made several assumptions.
These assumptions, as well as the differences in contract speciﬁcations, result
2Note that while the difference between the ﬁnancing cost and the cash yield is a
negative value, carry is said to be positive.

Derivatives for Controlling Risk 361
in the futures price in the market deviating from the theoretical futures
price as given by equation (14.1). It may be possible to incorporate theseinstitutional and contract speciﬁcation differences into the formula for the
theoretical futures price. In general, however, because it is often too difﬁcult

to allow for these differences in building a model for the theoretical futuresprice, the end result is that one can develop bands or boundaries for the
theoretical futures price. So long as the futures price in the market remains
within the band, no arbitrage opportunity is possible.
There are some institutional and contract speciﬁcation differences that
cause prices to deviate from the theoretical futures price, as given by thebasic pricing model:

■Interim cash ﬂows. In the derivation of a basic pricing model, we assume
that no interim cash ﬂows arise because of changes in futures prices (that
is, there is no variation margin). As noted earlier, in the absence of initial
and variation margins, the theoretical price for the contract is technicallythe theoretical price for a forward contract that is not marked to market,
rather than a futures contract.
In addition, the model assumes implicitly that any dividends or

coupon interest payments are paid at the settlement date of the futurescontract rather than at any time between initiation of the cash position
and settlement of the futures contract. However, we know that theunderlying for ﬁnancial futures contracts (such as stock index futures
contracts and bond futures contracts) do have interim cash ﬂows.
■Differences in borrowing and lending rates. In the formula for the the-
oretical futures price, it is assumed in the cash-and-carry trade and the

reverse cash-and-carry trade that the borrowing rate and lending rate
are equal. Typically, however, the borrowing rate is higher than thelending rate. The impact of this inequality is that there is a band of
futures prices; within this band, there are no arbitrage opportunities.
■Transaction costs . The two strategies to exploit any price discrepancies
between the cash market and theoretical price for the futures contract

require the arbitrageur to incur transaction costs. In real-world ﬁnan-cial markets, the costs of entering into and closing the cash position,
as well as round-trip transaction costs for the futures contract, affect
the futures price. As in the case of differential borrowing and lend-ing rates, transaction costs widen the bands for the theoretical futures
price.
■Short selling . The reverse cash-and-strategy trade requires the short

selling of the underlying. It is assumed in this strategy that the proceedsfrom the short sale are received and reinvested. In practice, for individual
investors, the proceeds are not received, and, in fact, the individual

362 VALUATION AND ANALYSIS TOOLS
investor is required to deposit margin (securities margin and not futures
margin) to short sell.
For institutional investors, the underlying may be borrowed, but

there is a cost to borrowing. This cost of borrowing can be incorpo-rated into the model by reducing the cash yield on the underlying. Forstrategies applied to stock index futures, a short sale of the components
stocks in the index means that all stocks in the index must be sold si-
multaneously. This may be difﬁcult to do and, therefore, would widenthe band for the theoretical future price.

■Deliverable is a basket of securities. Some futures contracts have as theunderlying a basket of assets or an index, rather than a single asset.Stock index futures are the most obvious example.
Using Futures and Forward Contracts
As we explained, futures and forward contracts can be used for leverage.It is the misuse of these contracts, indeed the misuse of all derivatives de-
scribed in this chapter, by corporate treasurers and investment managers

for speculative purposes (i.e., betting on something occurring) that is oftendiscussed in the media. But derivatives provide a means for controlling risk,
as the illustrations to follow will make clear. The focus of the media is on
those cases of misusing derivatives, not on how participants in the ﬁnancialmarket have used derivatives to successfully protect against major losses due
to adverse movements in prices, foreign exchange, or interest rates.

It is important to note that futures and forward contracts are risk-
sharing instruments. This means that both parties to the transaction aresharing the risk associated with the underlying. So if the underlying is, say,
a commodity such as wheat, then both parties to a trade are exposed to theprice risk of wheat. One party will be exposed to the price of wheat declining
(the long position) and the other party will be exposed to the price of wheat
increasing (the short position).

Let’s continue with the wheat example for our ﬁrst application. Consider
the economic exposure to price risk by a farmer who grows wheat and a foodmanufacturer that uses wheat to create its products. The farmer is exposed to
the risk that the price of wheat will decline by the time the wheat is brought
to market. The food manufacturer is exposed to the risk that the price ofwheat will increase in the future and therefore the cost of one of its major

inputs will increase. If both the farmer and the food manufacturer wanted to
basically eliminate their respective exposures to the price risk associated withwheat, they can do so by using futures contracts. The farmer could lock in a
future price for wheat by buying a futures contract; the food manufacturer
could lock in a future price for wheat by selling a futures contract. Thus,

Derivatives for Controlling Risk 363
each party has shifted the undesired price risk to the other party. Notice that
neither party will beneﬁt if there is favorable price movement for wheat. Thatis, if the price of wheat rises in the future, the farmer cannot beneﬁt; if the
price of wheat declines in the future, the food manufacturer cannot beneﬁt.

The same situation applies to entities that have exposure to changes in
a foreign currency. The price of a foreign currency is given by the exchangerate between two currencies. Suppose the two currencies are the U.S. dollar
and the euro. A U.S. manufacturer that sells products in France and is paidin euros by the French customer is concerned that the value of the euro will
decline (i.e., depreciate) relative to the U.S. dollar. In contrast, another U.S.

manufacturer who buys material from a ﬁrm in Spain and must pay for thatmaterial in euros is concerned that the euro will increase (i.e., appreciate)
relative to the U.S. dollar. To protect against the adverse ﬂuctuation of the
currency, the two U.S. manufacturing ﬁrms can take the appropriate position
in foreign exchange futures or forward contracts.
As our ﬁnal application, suppose a corporate treasurer knows that $200

million must be borrowed six months from now. The concern that thecorporate treasurer has is that in the future interest rates may rise, making
the cost of borrowing more expensive. Suppose that the portfolio manager ofa pension fund knows that six months from now there will be $200 million
in cash inﬂows to invest and plans to invest that sum in bonds. The risk faced

by the portfolio manager is that interest rates will decline and therefore theportfolio will earn a lower interest rate on the funds invested six months
from now. Again, both the corporate treasurer and the portfolio manager
are exposed to an unfavorable movement in something; that something inthis case is interest rates. But once again what is an adverse movement to
one party is a favorable one to the other party. To protect against an adverse

movement in interest rates, there are interest rate futures contracts that thetwo parties can employ.
OPTIONS
We now turn to another derivative instrument, an option contract. An option
is a contract in which the option seller grants the option buyer the right toenter into a transaction with the seller to either buy or sell an underlying
asset at a speciﬁed price on or before a speciﬁed date.
Basic Features of Options
An investor who buys an option has the choice of exercising it—that is,

buying the underlying asset—or not. Unlike a futures contract, the investor

364 VALUATION AND ANALYSIS TOOLS
in an option can simply not do anything, letting the option expire. The
option seller grants this right in exchange for a certain amount of money,which is the option premium oroption price. The option seller is the option
writer , while the option buyer is the option holder.
The speciﬁed price that the option buyer may buy or sell the underlying

is the strike price orexercise price which is ﬁxed in the option contract. The
speciﬁed date is the expiration date.
The asset that is the subject of the option is the underlying, and the
underlying can be an individual stock, a stock index, a bond, or even another
derivative instrument, such as a futures contract. The option writer can grant

the option holder one of two rights. If the right is to purchase the underlying,the option is a call option. If the right is to sell the underlying, the option is
aput option.
We can categorize an option according to when it may be exercised by
the buyer. This is the exercise style. A European option can only be exercised
at the expiration date of the contract. An American option , in contrast, can
be exercised any time on or before the expiration date. An option that

can be exercised before the expiration date, but only on speciﬁed dates is
called a Bermuda option or an Atlantic option .
The terms of the exchange are represented by the contract unit and are
standardized for most contracts. The option holder enters into the contractwith an opening transaction. Subsequently, the option holder then has thechoice to exercise or to sell the option. The sale of an existing option by the
holder is a closing sale.

Let’s use an illustration to demonstrate the fundamental option contract.
Suppose that Jack buys a call option for $3 (the option price) with thefollowing terms:
Feature Speciﬁcation
Underlying One unit of asset ABC
Exercise price $100
Expiration date 3 months from now
Exercise style American
At any time up to and including the expiration date, Jack can decide to

buy from the writer of this option one unit of asset ABC, for which he willpay a price of $100. If it is not beneﬁcial for Jack to exercise the option,he will not; we’ll explain shortly how he decides when it will be beneﬁcial.
Whether Jack exercises the option or not, the $3 he paid for it will be kept
by the option writer.

Derivatives for Controlling Risk 365
If Jack buys a put option rather than a call option, then he would be
able to sell asset ABC to the option writer for a price of $100. Like the call
option, he will only exercise the put option if it is beneﬁcial to do so.
The maximum amount that an option buyer can lose is the op-

tion price. The maximum proﬁt that the option writer can realize is theoption price. The option buyer has substantial upside return potential,
while the option writer has substantial downside risk. We’ll investigate the
risk/reward relationship for option positions later in this chapter.
Options, like other ﬁnancial instruments, may be traded either on an

organized exchange or in the over-the-counter (OTC) market. The advan-tages of an exchange-traded option are as follows. First, the exercise priceand expiration date of the contract are standardized. Second, as in the case
of futures contracts, the direct link between buyer and seller is severed after
the order is executed because of the interchangeability of exchange-traded
options. The clearinghouse associated with the exchange where the option

trades performs the same function in the options market that it does in thefutures market. Finally, the transactions costs are lower for exchange-traded
options than for OTC options.
The higher cost of an OTC option reﬂects the cost of customizing the
option for the many situations where a corporation seeking to use an optionto manage risk needs to have a tailor-made option because the standardized

exchange-traded option does not satisfy its objectives. Some commercial andinvestment and banking ﬁrms act as principals as well as brokers in the OTC
options market. OTC options are sometimes referred to as dealer options.
While an OTC option is less liquid than an exchange-traded option, this is
typically not of concern to the user of such an option.
Differences Between Options
and Futures Contracts
Notice that, unlike in a futures contract, one party to an option contract

is not obligated to transact—speciﬁcally, the option buyer has the right but
not the obligation to transact. The option writer does have the obligation to
perform. This is different than in the case of a futures contract where bothbuyer and seller are obligated to perform.
3
Consequently, the risk/reward characteristics of the two contracts are
also different. In the case of a futures contract, the buyer of the contractrealizes a dollar-for-dollar gain when the price of the futures contract in-

creases and suffers a dollar-for-dollar loss when the price of the futures
3Of course, a futures buyer does not pay the seller to accept the obligation, while an
option buyer pays the seller the option price.

366 VALUATION AND ANALYSIS TOOLS
contract drops. The opposite occurs for the seller of a futures contract.
Because of this relationship, futures are referred to as having a “linearpayoff.”
Options do not provide this symmetric risk/reward relationship. The

most that the buyer of an option can lose is the option price. While the buyerof an option retains all the potential beneﬁts, the gain is always reduced by
the amount of the option price. The maximum proﬁt that the writer may
realize is the option price; this is offset against substantial downside risk.Because of this characteristic, options are referred to as having a nonlinear
payoff .
The difference in the type of payoff between futures and options is

extremely important because market participants can use futures to protect
against symmetric risk and options to protect against asymmetric risk.
Risk and Return of Options
Here we illustrate the risk and return characteristics of the four basic optionpositions—buying a call option, selling a call option, buying a put option,
and selling a put option. The illustrations assume that each option positionis held to the expiration date and not exercised early. Also, to simplify the

illustrations, we ignore transactions costs.
Buying Call Options The purchase of a call option creates a position re-
f e r r e dt oa salong call position. To illustrate this position, assume that there
is a call option on Asset X that expires in one month and has an exercise
price of $60. The option price is $2. What is the proﬁt or loss for the investor
who purchases this call option and holds it to the expiration date?
The proﬁt and loss from the strategy will depend on the price of As-

set X at the expiration date. A number of outcomes are possible.
4We
4In addition, the illustrations do not address the cost of ﬁnancing the purchase of
the option price or the opportunity cost of investing the option price. Speciﬁcally,
the buyer of an option must pay the seller the option price at the time the optionis purchased. Thus, the buyer must ﬁnance the purchase price of the option or,
assuming the purchase price does not have to be borrowed, the buyer loses the

income that can be earned by investing the amount of the option price until theoption is sold or exercised. In contrast, assuming that the seller does not have to use
the option price as margin for the short position or can use an interest-earning asset as
security, the seller has the opportunity to earn income from the proceeds of the optionsale.

Derivatives for Controlling Risk 367
provide the detail calculations for prices of Asset X between $58 and
$65:
Price ofAsset X Exercise? CalculationOption
Buyer Proﬁt
or Loss
$58 No −$2
$59 No −$2
$60 No −$2
$61 Yes $61 −60−2=− $1
$62 Yes $62 −60−2= $0
$63 Yes $63 −60−2= $1
$64 Yes $64 −60−2= $2
$65 Yes $65 −60−2= $3

■If the price of Asset X at the expiration date is less than or equal to $60
(the option price), the investor will not exercise the option.
It would be foolish to pay the option writer $60 when Asset X can
be purchased in the market at a lower price. In this case, the optionbuyer loses the entire option price of $2.
■If Asset X’s price is more than $60 the option buyer will exercise the
option.

option.
■If less than $62 at the expiration date, the option buyer will exer-cise the option. By exercising, the option buyer can purchase Asset Xfor $60 (the exercise price) and sell it in the market for the higher
price.
■If Asset X’s price at the expiration date is equal to $62 the in-
vestor breaks even, realizing a gain of $2 that offsets the cost of the
option, $2.
■If Asset X’s price at the expiration date is more than $62, the investorwill exercise the option and realize a proﬁt.

Writing (Selling) Call Options The writer of a call option is said to be in
ashort call position. To illustrate the option seller’s (i.e., writer’s) position,
we use the same call option we used to illustrate buying a call option.
The proﬁt and loss proﬁle of the short call position (that is, the position ofthe call option writer) is the mirror image of the proﬁt and loss proﬁle of
the long call position (the position of the call option buyer). Consider the

368 VALUATION AND ANALYSIS TOOLS
proﬁt or loss for the option writer for prices of Asset X between $58 and
$65:
Price ofAsset XWill the Option
Buyer Exercise? CalculationOption Writer
Proﬁt or Loss
$58 No $2
$59 No $2
$60 No $2
$61 Yes $60 −61+2= $1
$62 Yes $60 −62+2= $0
$63 Yes $60 −63+2=− $1
$64 Yes $60 −64+2=− $2
$65 Yes $60 −65+2=− $3

Consequently, the maximum proﬁt that the short call position can pro-
duce is the option price. The maximum loss is not limited because it is the
highest price reached by Asset X on or before the expiration date, less the
option price; this price can be indeﬁnitely high.
We provide a graph of the proﬁt/loss proﬁle for both the option buyer

and the option writer for this option in Exhibit 14.2 for prices of the under-lying from $40 to $70. As you can see in this graph, That is, the proﬁt ofthe short call position for any given price for Asset X at the expiration date
is the same as the loss of the long call position.
–$12–$8–$4$0$4$8$12
$40 $45 $50 $55 $60 $65 $70
Price of the UnderlyingProfit or LossCall option buyer Call option writer
EXHIBIT 14.2 Proﬁt or Loss for the Call Option Buyer and Writer for an

Derivatives for Controlling Risk 369
TRY IT! THE PAYOFF FROM A CALL OPTION
Suppose you buy a call option with an exercise price of $50, paying
an option premium of $3. If the underlying stock’s price is $60 at the
time you exercise this option, what is your proﬁt on this option?
Buying Put Options The buying of a put option creates a ﬁnancial position

referred to as a long put position . To illustrate this position, we assume a
hypothetical put option on one unit of Asset Y with one month to maturityand an exercise price of $100. Assume the put option is selling for $3. The
proﬁt or loss for this position at the expiration date depends on the marketprice of Asset Y. Consider the possible outcomes for the put option buyer
for prices of Asset Y from $93 to $103:
Price of
Asset Y Exercise? CalculationOption Buyer

$93 Yes $100 −93−3= $4
$94 Yes $100 −94−3= $3
$95 Yes $100 −95−3= $2
$96 Yes $100 −96−3= $1
$97 Yes $100 −97−3= $0
$98 Yes $100 −98−3=− $1
$99 Yes $100 −99−3=− $2
$100 No −$3
$101 No −$3
$102 No −$3
$103 No −$3
■If Asset Y’s price is greater than $100, the buyer of the put option willnot exercise it because exercising would mean selling.

■If the price of Asset Y at expiration is equal to $100, the buyer of theput option will not exercise it, leaving the put buyer with a loss equalto the option price of $3.
■Any price for Asset Y that is less than $100 but greater than $97 willresult in a loss; exercising the put option, however, limits the loss to lessthan the option price of $2.
■At a $97 price for Asset Y at the expiration date, the put buyer willbreak even. The investor will realize a gain of $3 by selling Asset Y

370 VALUATION AND ANALYSIS TOOLS
to the writer of the option for $100, offsetting the cost of the option,
the $3.
■If Asset Y’s price is below $97 at the expiration date, the long put
position (the put buyer) will realize a proﬁt.
Writing (Selling) Put Options Writing a put option creates a position re-
ferred to as a short put position. The proﬁt and loss proﬁle for a short put

option is the mirror image of the long put option. The maximum proﬁtfrom this position is the option price. The theoretical maximum loss can be
substantial should the price of the underlying fall; at the extreme, if the pricewere to fall all the way to zero, the loss would be as large as the exercise
price less the option price.
In the case of the option on Asset Y, with an exercise price of $100 and
an option premium of $3:
Price ofAsset Y Exercise? CalculationOption Writer

$93 Yes $100 −93−3=− $4
$94 Yes $100 −94−3=− $3
$95 Yes $100 −95−3=− $2
$96 Yes $100 −96−3=− $1
$98 Yes $100 −98−3=+ $1
$99 Yes $100 −99−3=+ $2
$100 No +$3
$101 No +$3
$102 No +$3
$103 No +$3
We provide the proﬁt and loss proﬁle for the long put position in graphi-
cal form in Exhibit 14.3. As with all long option positions, the loss is limited
to the option premium paid by the investor. The proﬁt potential, however,

is substantial: The theoretical maximum proﬁt is generated if Asset Y’s price
falls to zero. Contrast this proﬁt potential with that of the buyer of a call op-tion. The theoretical maximum proﬁt for a call buyer cannot be determined
beforehand because it depends on the highest price that can be reached by
Asset Y before or at the option expiration date.
To summarize, buying calls or selling puts allows the investor to gain

if the price of the underlying rises. Selling calls and buying puts allows theinvestor to gain if the price of the underlying falls.

Derivatives for Controlling Risk 371
–$20–$16–$12–$8–$4$0$4$8$12$16$20
$80 $85 $90 $95 $100 $105 $110
Price of the UnderlyingProfit or LossPut option buyer Put option writer
EXHIBIT 14.3 Proﬁt or Loss for the Put Option Buyer and Writer for an
Option with an Exercise Price of $100 and a $3 Option Premium
TRY IT! THE PAYOFF FROM A PUT OPTION

Suppose you buy a put option with an exercise price of $50, paying an
option premium of $3. If the underlying stock’s price is $48 at the timeyou exercise this option, what is your proﬁt or loss on this option?
Basic Components of the Option Price
The option price is a reﬂection of the option’s intrinsic value and any addi-
tional amount over its intrinsic value. The premium over intrinsic value isoften referred to as the time premium.

As with futures and forward contracts, the theoretical price of an option
is also derived from arguments based on arbitrage. However, the pricing ofoptions is not as simple as the pricing of futures and forward contracts. Thetheoretical price of an option is made up of two components: the intrinsic
value and a premium over intrinsic value.
The intrinsic value is the option’s economic value if it is exercised

immediately. If no positive economic value would result from exercisingimmediately, the intrinsic value is zero. An option’s intrinsic value is easy to
compute given the price of the underlying and the strike price.

372 VALUATION AND ANALYSIS TOOLS
For a call option, the intrinsic value is the difference between the current
market price of the underlying and the strike price. If that difference is
positive, then the intrinsic value equals that difference; if the difference is zero
or negative, then the intrinsic value is equal to zero. For example, if the strike

price for a call option is $100 and the current price of the underlying is $109,the intrinsic value is $9. That is, an option buyer exercising the option and
simultaneously selling the underlying would realize $109 from the sale of
the underlying, which would be covered by acquiring the underlying fromthe option writer for $100, thereby netting a $9 gain.
An option that has a positive intrinsic value is said to be in-the-money .

When the strike price of a call option exceeds the underlying’s market price,it has no intrinsic value and is said to be out-of-the-money. An option for
which the strike price is equal to the underlying’s market price is said tobeat-the-money. Both at-the-money and out-of-the-money options have
intrinsic values of zero because it is not proﬁtable to exercise them. Our calloption with a strike price of $100 would be:
■in the money when the market price of the underlying is more than$100;

■out of the money when the market price of the underlying is less than$100; and
■at the money when the market price of the underlying is $100.
For a put option, the intrinsic value is equal to the amount by which
the underlying’s market price is below the strike price. For example, if the
strike price of a put option is $100 and the market price of the underlying
is $95, the intrinsic value is $5. That is, the buyer of the put option who

simultaneously buys the underlying and exercises the put option will net$5 by exercising. The underlying will be sold to the writer for $100 and
purchased in the market for $95. With a strike price of $100, the put option
would be (1) in the money when the underlying’s market price is less than
$100; (2) out of the money when the underlying’s market price exceeds $100;
and (3) at the money when the underlying’s market price is equal to $100.

The time premium of an option, also referred to as the time value of the
option, is the amount by which the option’s market price exceeds its intrinsicvalue. It is the expectation of the option buyer that at some time prior to theexpiration date changes in the market price of the underlying will increase
the value of the rights conveyed by the option. Because of this expectation,

the option buyer is willing to pay a premium above the intrinsic value. Forexample, if the price of a call option with a strike price of $100 is $12 when
the underlying’s market price is $104, the time premium of this option is
$8 ($12 minus its intrinsic value of $4). Had the underlying’s market price

Derivatives for Controlling Risk 373
been $95 instead of $104, the time premium of this option would be the
entire $12 because the option has no intrinsic value. All other things beingequal, the time premium of an option will increase with the amount of time
remaining to expiration.
An option buyer has two ways to realize the value of an option position.

The ﬁrst way is by exercising the option. The second way is to sell the optionin the market. In the ﬁrst example above, selling the call for $12 is preferable
to exercising, because the exercise will realize only $4 (the intrinsic value),but the sale will realize $12. As this example shows, exercise causes the
immediate loss of any time premium. It is important to note that there

are circumstances under which an option may be exercised prior to theexpiration date. These circumstances depend on whether the total proceeds
at the expiration date would be greater by holding the option or exercising
and reinvesting any received cash proceeds until the expiration date.
Factors That Influence an Option’s Price The factors that affect the price
of an option include:
1.Market price of the underlying.
2.Strike price of the option.
3.Time to expiration of the option.

4.Expected volatility of the underlying over the life of the option.
5.Short-term, risk-free interest rate over the life of the option.
6.Anticipated cash payments on the underlying over the life of the option.The impact of each of these factors may depend on whether (1) the
option is a call or a put, and (2) the option is an American option or a

European option. We summarize these factors in Exhibit 14.4 and how eachof the six factors listed above affects the price of a put and call option. Here,
we brieﬂy explain why the factors have the particular effects.
■Market price of the underlying asset. The option price will change as
the price of the underlying changes. For a call option, as the underly-
ing’s price increases (all other factors being constant), the option price

increases. The opposite holds for a put option: As the price of the un-
derlying increases, the price of a put option decreases.
■Strike price. The strike price is ﬁxed for the life of the option. All other
factors being equal, the lower the strike price, the higher the price for acall option. For put options, the higher the strike price, the higher theoption price.

■Time to expiration of the option. After the expiration date, an op-tion has no value. All other factors being equal, the longer the time to

374 VALUATION AND ANALYSIS TOOLS
EXHIBIT 14.4 Summary of Factors that Affect the Price of an Option
Effect of an Increase
of a Factor on the ...
FactorCall
OptionPricePutOptionPrice
Market price of the underlying /barb4up/barb4down
Strike price of the option /barb4down/barb4up
Time to expiration of the option /barb4up/barb4up
Expected volatility of the underlying over the life of the

option /barb4up/barb4up
Short-term, risk-free interest rate over the life of the
option /barb4up/barb4down
Anticipated cash payments on the underlying over the
life of the option /barb4down/barb4up
expiration of the option, the higher the option price. This is because, as
the time to expiration decreases, less time remains for the underlying’s
price to rise (for a call buyer) or fall (for a put buyer), and thereforethe probability of a favorable price movement decreases. Consequently,

as the time remaining until expiration decreases, the option price ap-
proaches its intrinsic value.
■Expected volatility of the underlying over the life of the option . All other
factors being equal, the greater the expected volatility (as measured bythe standard deviation or variance) of the underlying, the more theoption buyer would be willing to pay for the option, and the more an
option writer would demand for it. This occurs because the greater the

expected volatility, the greater the probability that the movement of the
underlying will change so as to beneﬁt the option buyer at some time
before expiration.
■Short-term, risk-free interest rate over the life of the option . Buying
the underlying requires an investment of funds. Buying an option onthe same quantity of the underlying makes the difference between theunderlying’s price and the option price available for investment at an

interest rate at least as high as the risk-free rate. Consequently, all other
factors being constant, the higher the short-term, risk-free interest rate,the greater the cost of buying the underlying and carrying it to the
expiration date of the call option. Hence, the higher the short-term,
risk-free interest rate, the more attractive the call option will be relative

Derivatives for Controlling Risk 375
to the direct purchase of the underlying. As a result, the higher the
short-term, risk-free interest rate, the greater the price of a call option.
■Anticipated cash payments on the underlying over the life of the option.
Cash payments on the underlying tend to decrease the price of a call

option because the cash payments make it more attractive to hold theunderlying than to hold the option. For put options, cash payments on
the underlying tend to increase the price.
Option Pricing Models Earlier in this chapter, we explained how the theo-
retical price of a futures contract and forward contract is determined basedon arbitrage arguments. An option pricing model uses a set of assumptions

and arbitrage arguments to derive a theoretical price for an option. Derivinga theoretical option price is much more complicated than deriving a the-
oretical futures or forward price because the option price depends on the
expected volatility of the underlying over the life of the option.
Several models have been developed to determine the theoretical price of
an option. The most popular one was developed by Fischer Black and MyronScholes for valuing European call options on common stock.

5Because of
the technical nature of this model, we describe it in the appendix to this
chapter.
Using Options
Unlike futures and forward contracts, which are risk-sharing instruments,
options are insurance-type instruments . The buyer of the option pays the
seller/writer of the option the option price to obtain the desired protection.
This is the reason the option price is often referred to as the option premium,

the term used in the insurance industry for the cost of buying insurance.Because an option contract obligates only the seller and not the buyer to
perform, a party that buys an option can beneﬁt from a favorable movement
in the underlying. Recall that when we discussed the use of futures andforward contracts, that was not an attribute of those instruments.
Let’s look at how the wheat farmer and the food manufacturer in our

earlier discussion on the applications of futures and forward contracts could
have used options. To protect against a decline in the price of wheat, the
farmer could purchase a put option on wheat. The minimum price at whichthe farmer could then sell wheat is the exercise price of the option. However,
5Fischer Black and Myron Scholes, “Pricing of Options and Corporate Liabilities,”
Journal of Political Economy 81(1973): 637–654.

376 VALUATION AND ANALYSIS TOOLS
since the farmer must pay the option price, the effective sale price for wheat
by buying the option is the exercise price reduced by the cost of the option.Notice that this is the downside price risk for the farmer. The farmer will
beneﬁt from an increase in the price of wheat, but that upside is reduced by
the cost of the option.

The food manufacturer can buy a call option on wheat. By doing so,
the food manufacturer knows that it will not have to pay more for wheatthan the exercise price. Since the food manufacturer must pay the optionpremium, the effective maximum price that the food manufacturer will have
to pay for wheat is the sum of the exercise price and the cost of the option.

Should the price of wheat decline, the food manufacturer can beneﬁt, butthe savings from the price decline are reduced by the cost of the option.
SWAPS
Aswap is an agreement whereby two parties (called counterparties) agree to
exchange periodic payments. The dollar amount of the payments exchangedis based on some predetermined dollar principal, which is called the notional
principal amount or simply notional amount . The dollar amount each coun-

terparty pays to the other is the agreed-upon periodic rate multiplied by thenotional amount. The only dollars exchanged between the parties are the
agreed-upon payments, not the notional amount.
A swap is an over-the-counter contract. Hence, the counterparties to a
swap are exposed to counterparty risk.
We look at four types of swaps—interest rate swaps, currency swaps,

commodity swaps, and credit default swaps—that are the most commonswaps used by businesses. We illustrate these types of swaps in this section.
Interest Rate Swap
In an interest rate swap, the counterparties swap payments in the same
currency based on an interest rate. For example, one of the counterparties
can pay a ﬁxed interest rate and the other party a ﬂoating interest rate. The
ﬂoating interest rate is commonly referred to as the reference rate.

For example, suppose the counterparties to a swap agreement are Farm
Equip Corporation (a manufacturing ﬁrm) and PNC Bank. The notionalamount of this swap is $100 million and the term of the swap is ﬁve years.
Every year for the next ﬁve years, Farm Equip Corporation agrees to payPNC Bank 8% per year, while PNC Bank agrees to pay Farm Equip Cor-
poration the one-year LIBOR as the reference rate. This means that every
year, Farm Equip Corporation will pay $8 million (8% times $100 million)

Derivatives for Controlling Risk 377
to PNC Bank. The amount PNC Bank will pay Farm Equip Corporation
depends on LIBOR. For example, one-year LIBOR is 6%, PNC Bank willpay Farm Equip Corporation $6 million (6% times $100 million).
The best advice may be this: treat exotic derivatives like powerfulmedicines, large doses of which can be harmful. Use them in moder-

ation, for a particular purpose (such as risk management) and only
after having read the instructions on the bottle.
—Philippe Jorion, Bad Bets Gone Bad
(New York: Academic Press, 1995), p. 57
Taking this a step further, if the LIBOR is 6%,
PNC Bank pays
$7 millionFarm Equip
Corporation
pays $8 million
Only the net cash ﬂow is actually exchanged, so in this case Farm Equip
pays $1 million to PNC Bank. If, instead, the LIBOR is 9%,
$10 millionFarm Equip

In this case the net cash ﬂow is $2 million, paid from PNC to Farm
Equip Corporation.
Why use an interest rate swap? Though we’ll discuss this later in the
book when we discuss how a company ﬁnances itself, the motivation relatesto the costs of ﬁnancing, and whether the ﬁnancing is ﬁxed (such as the
commitment that Farm Equip has made) or ﬂoating (such as the commitment
that PNC Bank has made).

378 VALUATION AND ANALYSIS TOOLS
Currency Swaps
In acurrency swap, two parties agree to swap payments based on different
currencies. Companies use currency swaps to raise funds outside of their
home currency and then swap the payments into their home currency. This

allows a corporation with operations outside their home country to eliminatecurrency risk (i.e., unfavorable exchange rate or currency movements) when
borrowing outside of its domestic currency.
To illustrate a currency swap, suppose there are two counterparties:
High Quality Electronics Corporation (a U.S. manufacturing ﬁrm) andCitibank. The notional amount is $100 million and its Swiss franc (CHF)
equivalent. At the time the contract was entered into, $100 million was

equal to CHF 127 million. And suppose the swap term is eight years.
Every year for the next eight years the U.S. manufacturing ﬁrm agrees to payCitibank Swiss francs equal to 5% of the Swiss franc notional amount, or
CHF 6.35 million. In turn, Citibank agrees to pay High Quality Electronics
7% of the U.S. notional principal amount of $100 million, or $7 million. Ifthe exchange rate between the U.S. dollar and the CHF changes, the value
of what is exchanged changes.
Commodity Swaps

In a commodity swap , the exchange of payments by the counterparties is
based on the value of a particular physical commodity. Physical commodities
include precious metals, base metals, energy stores (such as natural gas
or crude oil), and food (including pork bellies, wheat, and cattle). Most
commodity swaps involve oil.
For example, suppose that the two counterparties to this swap agree-

ment are Comfort Airlines Company, a commercial airline, and PrebonEnergy (an energy broker). The notional amount of the contract is 1 million
barrels of crude oil each year and the contract is for three years. The swap
price is $19 per barrel. Each year for the next three years, Comfort AirlinesCompany agrees to buy 1 million barrels of crude oil for $19 per barrel. So,
each year Comfort Airlines Company pays $19 million to Prebon Energy

($19 per barrel times 1 million barrels) and receives 1 million barrels ofcrude oil.
The motive for Comfort Airlines of using the commodity swap is that
it allows the company to lock in a price for 1 million barrels of crude oilat $19 per barrel regardless of how high crude oil’s price increases over the
next three years.

Derivatives for Controlling Risk 379
Credit Default Swaps
Acredit default swap (CDS) is an OTC derivative that permits the buying
and selling of credit protection against particular types of events that can
adversely affect the credit quality of a bond such as the default of the bor-

rower. Although it is referred to as a “swap,” it does not follow the generalcharacteristics of a swap described earlier. There are two parties: the credit
protection buyer andcredit protection seller . Over the life of the CDS, the
protection buyer agrees to pay the protection seller a payment at speciﬁeddates to insure against the impairment of the debt of a reference entity due
to a credit-related event.
The reference entity is a speciﬁc issuer, say, Ford Motor Company. The

speciﬁc credit-related events are identiﬁed in the contract that will triggera payment by the credit protection seller to the credit protection buyer arereferred to as credit events. If a credit event does occur, the credit protection
buyer only makes a payment up to the credit event date and makes nofurther payment. At this time, the protection buyer is obligated to fulﬁllits obligation. The contract will call for the protection seller to compensate

for the loss in the value of the debt obligation. The speciﬁc method for
compensating the protection buyer is not important at this time for thisbrief description of this derivative contract.
■Derivatives are contracts whose value depends on some other asset.
Derivatives include futures contracts, forward contracts, options, and
swaps.
■The traditional purpose of derivative instruments is to provide an im-
portant opportunity to manage against the risk of adverse future price,

exchange rate, or interest rate movements.
■Futures contracts are creations of exchanges, which require initial mar-gin from parties. Each day positions are marked to market. Additionalmargin is required if the equity in the position falls below the main-
tenance margin. The clearinghouse guarantees that the parties to the
futures contract will satisfy their obligations.
■A forward contract differs in several important ways from a futures

contract. In contrast to a futures contract, the parties to a forward
contract are exposed to the risk that the other party to the contract willfail to perform. The positions of the parties may not necessarily marked
to market, so in such cases there are no interim cash ﬂows associated

380 VALUATION AND ANALYSIS TOOLS
with a forward contract. Finally, unwinding a position in a forward
contract may be difﬁcult.
■Both futures and forward contracts are risk-sharing instruments, allow-
ing a party to control risk by locking in a future value but giving up the
opportunity to beneﬁt from a favorable movement in the value of theunderlying.

■An option grants the buyer of the option the right either to buy from (inthe case of a call option) or to sell to (in the case of a put option) theseller (writer) of the option the underlying at the exercise (strike) price
by the option’s expiration date. The price that the option buyer pays to
the writer of the option is the option price or option premium.
■The most popular model used to determine the fair market value of an
option is the Black-Scholes option pricing model.

■The buyer of an option cannot realize a loss greater than the optionprice, and has all the upside potential. By contrast, the maximum gain
that the writer (seller) of an option can realize is the option price; thewriter is exposed to all the downside risk.

■Unlike futures and forward contracts that are risk-sharing instruments,options are insurance-type contracts. The buyer of the option pays theoption price to obtain protection against adverse movements in the value
of the underlying but maintains the upside potential (reduced by the cost
of the option).
■The option price consists of two components: the intrinsic value and the
time premium. The intrinsic value is the economic value of the option if

it is exercised immediately (except that if there is no positive economicvalue that will result from exercising immediately, then the intrinsic
value is zero). The time premium is the amount by which the option
price exceeds the intrinsic value.
■Swap contracts allow for the exchange of a set of cash ﬂows, and can
be based on interest rates, currency exchange rates, commodity prices,
or credit protection.
APPENDIX: BLACK-SCHOLES OPTION
PRICING MODEL

In the chapter, we explained the basic factors that affect the value of an
option, also referred to as the option price. The option price is a reﬂection
of the option’s intrinsic value and any additional amount over its intrin-sic value, called the time premium. In this appendix, we explain how the
theoretical price of a non-dividend-paying European call option can be deter-
mined using a well-known ﬁnancial model, the Black-Scholes option pricing

Derivatives for Controlling Risk 381
model . We do not provide the details with respect to how the model was
derived by its developers. Rather, we will set forth the basics of the model.
Recall that a European option is one that cannot be exercised prior to theexpiration date.
Basically, the idea behind the arbitrage argument in deriving the option

pricing model is that if the payoff from owning a call option can be replicatedby (1) purchasing the stock underlying the call option; and (2) borrowing
funds, then the price of the option will be (at most) the cost of creating the
payoff replicating strategy.
By imposing certain assumptions (to be discussed later) and using arbi-

trage arguments, the Black-Scholes option pricing model computes the fair(or theoretical) price of a European call option on a non-dividend-payingstock with the following equation:
C=SN(d
1)−Xe−rtN(d2) (14A.1)
where:
d1=ln(S/
X)
+(
r+0.5s2)
t
s√t;
d2=d1−s√t;
ln=Natural logarithm;
C=Call option price;
S=Price of the underlying asset;
X=Strike price;
r=Short-term risk-free rate;
e=2.718 (the natural antilog of 1);
t=Time remaining to the expiration date, as a fraction of a year;

s=Standard deviation of the value of the underlying asset; and
N(.)=Cumulative probability density.6
Notice that ﬁve of the factors that we indicated in the chapter that
inﬂuence the price of an option are included in the formula. Anticipated
cash dividends are not included because the model is for a non-dividend-
paying stock. In the Black-Scholes option pricing model, the direction of the
inﬂuence of each of these factors is the same as stated in the chapter. Four of

the factors—strike price, price of underlying asset, time to expiration, andrisk-free rate—are easily observed. The standard deviation of the price of
the underlying asset must be estimated.
6We obtain the value for N(.) from a normal distribution function that is tabulated
in most statistics textbooks or from spreadsheets that have this built-in function.

382 VALUATION AND ANALYSIS TOOLS
The option price derived from the Black-Scholes option pricing model is
“fair” in the sense that if any other price existed, it would be possible to earn
riskless arbitrage proﬁts by taking an offsetting position in the underlying
asset. That is, if the price of the call option in the market is higher than

that derived from the Black-Scholes option pricing model, an investor couldsell the call option and buy a certain quantity of the underlying asset. If the
reverse is true, that is, the market price of the call option is less than the
“fair” price derived from the model, the investor could buy the call optionand sell short a certain amount of the underlying asset. This process of
hedging by taking a position in the underlying asset allows the investor to
lock in the riskless arbitrage proﬁt.

To illustrate the Black-Scholes option pricing formula, assume the fol-
lowing values:
Stock price =S=$47
Strike price =X=$45
Risk-free rate of interest =r=10%
Time remaining to expiration =t=183 days ÷365 days =0.5
Expected price volatility =s=25%
Substituting these values into the Black-Scholes option pricing model,
we get
d
1=ln(47/
45)
+(
0.1+(0.5×0.252))
0.5
0.25√
0.5=0.6172
and
d2=0.6172 −0.25√
0.5=0.4404
From a normal distribution table,

N(0.6172) =0.7315 and N(0.4404) =0.6702
Substituting these values into equation (14A.1),
C=($47×0.7315) −$45(e−(0.10×0.5×0.6702))=$5.69
Therefore, the value of the call option is $5.69.
Let’s look at what happens to the theoretical option price if the expected
price volatility is 40% rather than 25%. Then

Derivatives for Controlling Risk 383
N(0.4719) =0.6815 and N(0.1891) =0.5750
Then
C=($47×0.6815) −$45(e−(0.10×0.5×0.5750))=$7.42
Notice that the higher the assumed expected price volatility of the un-
derlying asset, the higher the price of a call option.
In Exhibit 14.5A, we show the option value as calculated from the

Black-Scholes option pricing model for different assumptions concerning
the standard deviation (Panel A), the time remaining to expiration (Panel B),
and the risk-free rate of interest (Panel C). Notice that the option price variesdirectly with all three variables. That is,
■the higher the volatility, the higher the option price;
■the longer the time remaining to expiration, the higher the option price;
■the higher the risk-free rate, the higher the option price.

All of this agrees with what we stated in this chapter about the effect of
a change in one of the factors on the price of a call option.
The Black-Scholes option pricing model assumes that the call option is a
European call option. Because the model is for a non-dividend-paying stock,
early exercise of an option will not be economical because by selling ratherthan exercising the call option, the option holder can recoup the option’s
time premium.
Futures

Futures
1.Cash and carry
2.$2
Now Later
Sell futures $0 Pay off loan −$1,000
Borrow 1,000 Interest on loan −8
Buy Asset U −1,000 Deliver Asset U 1,010
Cash ﬂow $0 Cash ﬂow $2

384 VALUATION AND ANALYSIS TOOLS
     $0$5$10$15$20$25
65% 60% 55% 50% 45% 40% 35% 30% 25% 20%Value of the Call Option Value of the Call Option Value of the Call OptionStandard Deviation
$0 $2 $4 $6 $8 $10 
10% 9% 8% 7% 6% 5% 4% 3% 2% 1%100% 90% 80% 70% 60% 50% 40% 30% 20% 10%
Risk-Free Rate of Interest$0 $2 $4 $6 $8 $10

Risk-Free Rate of Interest$0 $2 $4 $6 $8 $10 
Time Remaining (as a percentage of a year)A. Changes in the standard deviation, all else held constant
B. Changes in the time to expiration, all else held constant
C. Changes in the risk-free rate of interest, all else held constant
EXHIBIT 14.5 The Value of an Option Based on the Black-Scholes Model

Derivatives for Controlling Risk 385
The payoff from a call option
Proﬁt =$60−50−3=$7
The payoff from a put option
Loss=$50−48−3=−$1
QUESTIONS
1.What is the difference between a cash and carry trade and a reverse cash
and carry trade?
2.If there is no arbitrage opportunity, what is the expected proﬁt from a
cash and carry in futures?
3.What is the difference between forwards and futures?

4.If a call option’s exercise price is $100 and the underlying is currently$90, is this option in, at, or out of the money?
5.If the payoff of a call option at a speciﬁed price is $5, what is the payofffor the call writer at that price?
6.What is the relation between the time to expiration and the value of a:
a.call option?
b.put option?
7.What is the relation between the volatility of the price of the underlyingand the value of a:

8.If you believe that a stock’s price will fall over the next few months,what option transaction are you most likely to use?
9.If you believe that a stock’s price will fall over the next few months,what option transactions are you most likely to use?
10.What is the transaction that involves one party agreeing to pay a ﬁxed
interest rate, based on a notional amount, and the other party agreeing
to pay interest that is pegged to some reference rate?

11.The following appears in the 2000 10-K of International Business
Machines:
The company employs a number of strategies to manage these
risks, including the use of derivative ﬁnancial instruments.
Derivatives involve the risk of non-performance by the coun-
terparty.
Explain what is meant in the last sentence of this quotation.

386 VALUATION AND ANALYSIS TOOLS
12.A manufacturer of furniture is concerned that the price of lumber will
increase over the next three months. Explain how the manufacturercan protect against a rise in the price of lumber using lumber futures
13.The chief ﬁnancial ofﬁcer of the corporation you work for recently told

you that he had a strong preference to use forward contracts rather than
futures contracts to hedge: “You can get contracts tailor-made to suit
your needs.”a.Comment on the CFO’s statement.
b.What other factors inﬂuence the decision to use futures or forwardcontracts?
14.What is the difference between a put option and a call option?
15.What distinguishes an American option from a European option?
16.“There’s no real difference between options and futures. Both are tools

for controlling risk, and both are derivative products. It’s just that with
options you have to pay an option price, while futures require no up-front payment except for a good-faith margin. I can’t understand why
anyone would use options.” Do you agree with this statement?
17.The treasurer of the KSiR Corporation is attempting to manage risks
using options.
a.What option strategy can the treasurer take to protect against a rise

in the cost of one of the company’s inputs in the production process,assuming that there is an option available?
b.What option strategy can the treasurer take to protect against adecline in the selling price of one of the company’s products assumingthat there is an option available?
18.How does the price of an option and the exercise price affect the payofffrom an option.
19.Suppose that the price of the underlying is $40 and that the option price
is $5.

is $5.
a.If the exercise price for a put option is $42, what are the intrinsic
value and the time premium for this option?
b.If the exercise price for a call option is $50, what are the intrinsic
20.Orono Bank and the Portland Manufacturing Corp. enter into the fol-lowing seven-year swap with a notional amount of $75 million and thefollowing terms: Every year for the next seven years, Orono Bank agrees

to pay Portland Manufacturing 7% per year and receive LIBOR from
Portland Manufacturing.a.What type of swap is this?
b.In the ﬁrst year payments are to be exchanged, suppose that LIBORis 4%. What is the amount of the payment that the two parties mustmake to each other?

c15 JWBT310-Fabozzi July 1, 2010 16:18 Printer: Courier Westford, Westford, MA
PARTFour
387

388

CHAPTER15
Investors, who cannot or who will not take the trouble to
comprehend the laws that govern stock transactions, must be
content with a very moderate return. They may, if they choose,
learn the character of the risks, and understand the conditions ofsuccess, by the exercise of ordinary intelligence. No Prospero’s

wand is needed in order to avoid failure; but only common sense
and common prudence, such as all may cultivate.
On the other hand, there are no short and sure cuts to success. It
does not come by wishing and waiting for it. The proper meansmust be used, likely opportunities turned to advantage, and acareful judgment must be exercised. If it be thought that in one or
two transactions of ﬁve or ten thousand each a great fortune will

be instantly secured, there is certain to be a speedy process ofdisillusioning. Neither can it be expected that every venture will
prove lucrative. “The best laid schemes o’ mice an’ men gang aft
agley.” No mechanism is so automatically perfect in it workingas to be free from all risk of friction. It is the same with
investments. However carefully made, it sometimes happens that
unexpected complications arise, such as no foresight could have

anticipated or guarded against. Yet the law of averages is certain
to operate, as is the case with accidents, with ﬁres, and with everybusiness.
—William Hickman Smith Aubrey, Stock Exchange
Investments: Their History; Practice; and Results , 4th ed.
(London: Simpkin, Marshall, Hamilton Kent & Co. Ltd., 1897),
pp. 210–211
389

390 INVESTMENT MANAGEMENT
Aportfolio , simply put, is a group of investments. These investments may
include cash, common stocks, bonds, and real estate, among other assets,
and are managed for a speciﬁc objective or purpose.
Investment management —which is also known as portfolio manage-
ment ,asset management , and money management— is the process of man-

aging a portfolio. Accordingly, the individual who manages a portfolio of
investments is referred to as an investment manager,a portfolio manager,
anasset manager,o ramoney manager. In industry jargon, an investment
manager “runs money.” To be effective, the investment manager must un-derstand the various investment vehicles, the way these investment vehicles
are valued, and the various strategies to select the investment vehicles to

include in a portfolio to accomplish the investment objectives. The purposeof this chapter is to describe the process of investment management, which
can be applied to institutional investors or individual investors.
We illustrate the investment management process in Exhibit 15.1.
Though the process begins with setting the investment objective, it is reallya cyclical process where performance evaluation may result in feedback,

affecting changes to the objectives, policies, strategies, and composition of
the portfolio.
Measure &
evaluate
performanceSet the
objective
Establish the
policy
Select the
strategyConstruct
the portfolio
& monitor
EXHIBIT 15.1 The Investment Management Process

Investment Management 391
SETTING INVESTMENT OBJECTIVES
Setting investment objectives starts with a thorough analysis of the invest-
ment objectives of the entity whose funds are being managed. These entities
can be classiﬁed as individual investors and institutional investors. Within
each of these broad classiﬁcations is a wide range of investment objectives.

The objectives of an individual investor may be to accumulate funds to
purchase a home or other major acquisition, to have sufﬁcient funds to beable to retire at a speciﬁed age, or to accumulate funds to pay for collegetuition for children. An individual investor may engage the services of a
ﬁnancial advisor/consultant in establishing investment objectives.
Institutional investors include:
■Pension funds.
■Depository institutions (commercial banks, savings and loan associa-

tions, and credit unions).
■Insurance companies (life companies, property and casualty companies,and health companies).
■Regulated investment companies (mutual funds and closed-end funds).
■Hedge funds.
■Endowments and foundations.
■Treasury departments of corporations, municipal governments, andgovernment agencies.
No matter the investor, the ﬁrst step in the investment process is the
same: Set an objective for the portfolio.
Classification of Investment Objectives

In general, we can classify the investment objectives of investors into the
following two broad categories:
■Liability-driven objectives.
■Nonliability-driven objectives.
A liability in this context is a cash outlay that must be made at a speciﬁc
future date in order to satisfy the contractual terms of an obligation. For

example, a pension fund manager is concerned with both the amount andtiming of liabilities when managing a plan that has a deﬁned beneﬁt because
the portfolio must produce cash ﬂows to meet payments promised to retirees

392 INVESTMENT MANAGEMENT
in a timely way. Similarly, an individual may manage their investments to
meet speciﬁc a retirement objective or college tuition.
A portfolio managed for a nonliability objective is not seeking a particu-

lar cash ﬂow stream, but rather is managed to meet a return or risk objective.An example of an institutional investor that is not driven by liabilities is amutual fund.
Some institutional investors may have accounts that have both
nonliability-driven objectives and liability-driven objectives. For example, alife insurance company may have obligations that are ﬁxed in amount, such
as a guaranteed investment contract (GIC), and variable, as with a variable

annuity account. With a variable annuity account, an investor makes ei-ther a single payment or a series of payments to the life insurance company
and, in turn, the life insurance company invests the payments received and
makes payments to the investor at some future date. The payments that the
life insurance company makes depend on the performance of the insurance
company’s asset manager. While the life insurance company does have aliability, it does not guarantee any speciﬁc dollar payment.

Benchmark
Regardless of the type of investment objective, we need to establish a bench-mark to evaluate the performance of an asset manager. A benchmark is
a portfolio or index that is used for comparison purposes in evaluating aportfolio’s performance. The benchmark should be similar to the investor’s
investment objective in terms of the:
■Asset class or classes in the portfolio.
■Risk objective of the portfolio.
■Sensitivity to economic factors.

In some cases, determining a benchmark is fairly simple—and in other
cases, not. For example, in the case of a liability-driven objective, the bench-
mark is typically an interest rate target, where that interest rate is expected
to satisfy the needed cash ﬂow stream. In the case of a nonliability-driven
objective, the benchmark is typically the asset class in which the assets areinvested. For example, benchmarks for equity portfolios are often indexes,

such as the S&P 500 index.
There may not always be a readily available benchmark for a speciﬁc
investment objective, so it may be necessary to develop a customized bench-mark. The bottom line, however, is that the benchmark serves as a basis of
comparison for the performance of the portfolio.

Investment Management 393
ESTABLISHING AN INVESTMENT POLICY
The second major activity in the investment management process is estab-
lishing policy guidelines to satisfy the investment objectives. Setting policy
begins with the asset allocation decision. The asset allocation decision ad-

dresses the question: How should the portfolio’s investments be distributedamong the major asset classes? In other words, what should be the mix of
assets in the portfolio?
Asset Allocation
The term asset allocation means different things to different people and in
different contexts. We can divide asset allocation into three types:
1.Policy asset allocation.
2.Dynamic asset allocation.
3.Tactical asset allocation.1
We can loosely characterize policy asset allocation as a long-term asset

allocation decision, in which the investor seeks an appropriate long-term
asset mix that represents the risk and return consistent with the investmentobjective, seeking the greatest possible return for the appropriate level of
risk. Investors often use the mean-variance portfolio allocation model in
determining the policy asset allocation. The strategies that offer the greatest
prospects for strong long-term rewards to accomplish the investment ob-

jectives tend to be inherently risky strategies. The strategies that offer thegreatest safety tend to offer only modest return opportunities. Policy asset
allocation is the balancing of these conﬂicting goals.
Indynamic asset allocation, the asset mix is mechanistically shifted in
response to changing market conditions. Once the policy asset allocationhas been established, the investor can turn attention to the possibility of

active departures from the normal asset mix established by policy. That is,suppose that the long-run asset mix is established by the policy allocation
as 60% equities and 40% bonds. In dynamic asset allocation, a departure
from this mix may be allowed under certain circumstances. If a decision todeviate from this mix is based upon rigorous objective measures of value, we
refer to this as tactical asset allocation. Tactical asset allocation, however,
is not a single, clearly deﬁned strategy.

1Based on Robert D. Arnott and Frank J. Fabozzi, “The Many Dimensions of the
Asset Allocation Decision,” in Active Asset Allocation, ed. Robert D. Arnott and
Frank J. Fabozzi, 3–8 (Chicago: Probus, 1992).

394 INVESTMENT MANAGEMENT
Tactical asset allocation broadly refers to active strategies that seek
to enhance performance by opportunistically shifting the asset mix of a
portfolio in response to the changing patterns of reward available in the
capital markets. Notably, tactical asset allocation tends to refer to disciplined

processes for evaluating prospective rates of return on various asset classesand establishing an asset allocation response intended to capture higher
rewards.
Many variations and nuances are involved in building a tactical al-
location process. One of the problems in reviewing the concepts of assetallocation is that the same terms are often used for different concepts. The

term “dynamic asset allocation” has been used to refer to the long-termpolicy decision and to intermediate-term efforts to strategically position the
portfolio to beneﬁt from major market moves, as well as to refer to aggres-
sive tactical strategies. As an investor’s risk expectations and tolerance for
risk change, the normal or policy asset allocation may change.
A good portfolio is more than a long list of goods stocks and bonds.

It is a balanced whole, providing the investor with protections andopportunities with respect to a wide range of contingencies.
—Harry M. Markowitz, Portfolio Selection: Efﬁcient
Diversiﬁcation of Investments (New York:
John Wiley & Sons, 1959)
Asset Classes
We can classify investable investments into four major asset classes basedon the type and risk associated with the investments’ cash ﬂows and value,legal and regulation issues, and sensitivity to economic inﬂuences:
1.Common stocks
2.Bonds

2.Bonds
3.Cash equivalents
4.Real estate
Based on this way of deﬁning an asset class, the correlation between the
returns of different asset classes would be low.
We can extend the four major asset classes to create other asset classes.
For example, we can expand four major asset classes separating foreign se-
curities from domestic securities, as we show in Exhibit 15.2. Common
stocks are the ownership interests in a corporation, whereas bonds are

Investment Management 395
Investable
assets
Common
stocksBonds Cash equivalents Real estate
Domestic
common stocks
Foreign bondsForeign common
stocksDomestic bonds
EXHIBIT 15.2 Investable Assets and Traditional Asset Classes
indebtedness of an entity. Cash equivalents are liquid, low-risk investments
that can be, by deﬁnition, converted quickly into cash. Cash equivalents

include Treasury bills, certiﬁcates of deposit, and money market accounts.Real estate investments include physical property, as well as interests in real
estate, such as through real estate investment trusts. Our focus in this chap-
ter is on common stocks and bonds because these represent the predominantasset classes in most individual and institutional portfolios.
Common Stock Style Categories In the early 1970s, academic studies

found that there were categories of stocks that had similar characteristics
and performance patterns. Moreover, the returns of these stock categories
performed differently than did those of other categories of stocks. That is,
the returns of stocks within a category were highly correlated, and the re-turns between categories of stocks were relatively uncorrelated. In the latter
half of the 1970s, other studies suggested that an even simpler categorization

by size, produced different performance patterns.
Practitioners began to view these categories or clusters of stocks with
similar performance as a style of investing. Today, the notion of an equity
investment style is widely accepted in the investment community. We can
see the acceptance of equity style investing from the proliferation of style
indexes published by several vendors that serve as benchmarks for portfolios
managed according to different styles.

396 INVESTMENT MANAGEMENT
We can classify stocks by style in many ways. The most common is
in terms of one or more measures of growth and value. Within a growth
and value style, there is a substyle based on some measure of size, such
as market capitalization. The market capitalization of a corporation is the
total market value of its common stock outstanding, which is the product of

the price per share of stock and the number of shares of stock outstanding.
For example, suppose that a corporation has 500 million shares of common
stock outstanding and each share has a market value of $50. Then the marketcapitalization of this company is 500 million shares ×$50 per share =$25
billion. A company’s market capitalization is commonly referred to as itsmarket cap or, simply, cap. The most plain-vanilla classiﬁcation based on
market cap is:

■Large capitalization stocks (more than $10 billion).
■Mid-capitalization stocks (between $2 billion and $10 billion).
■Small capitalization stocks (between $300 million and $2 billion).
Other categories include mega-cap stocks (more than $200 billion),
micro-cap stocks (between $50 million and $300 million), and nano-cap
stocks (less than $50 million).
We can explain the motivation for the value/growth–style categories in

terms of the most commonly used measure for classifying stocks as growthor value—the price-to-book value per share (P/B) ratio. First, consider that
earnings growth increases the book value per share in (the denominator
of P/B). Second, assuming no change in the P/B ratio, a stock’s price willincrease if earnings grow (affecting the numerator of P/B).
An investment manager who is growth-oriented is concerned with earn-

ings growth, and seeks those stocks from a universe of stocks that havehigher relative earnings growth. The growth manager’s risks are that growth
in earnings does not materialize and/or that the P/B ratio decline. An invest-
ment manager who is value-oriented is concerned with the price rather than
with the future earnings growth. Value stocks within a universe of stocks

are viewed as “cheap” in terms of their P/B ratio. By cheap we mean that theP/B ratio is low relative to that of the universe of stocks. The expectation of
the manager who follows a value style is that the P/B ratio returns to some
normal level and, thus, even with book value per share constant, the pricewill rise. The risk is that the P/B ratio does not increase.
We can classify on the basis of whether the issuer is domestic or foreign.

Because the correlation of returns of stocks other nondomestic companiesmay not be highly correlated with those of the domestic corporations, there
are opportunities to increase diversiﬁcation within the common stock asset
class on the basis of the domicile of the issuing company.

Investment Management 397
Bond Investment Categories We can classify bonds different ways. One
way to classify bonds is to classify bonds by the issuer:
■Government bonds
■Municipal bonds
■Corporate bonds
■Asset-backed bonds
Government bonds are bonds issued by a country’s central government.
In the United States, these bonds are U.S. Treasury bonds that are indebted-

ness with maturities beyond one year. Municipal bonds are issued by state
and local governments. Corporate bonds, as the name implies, are issued by
corporations. Asset-backed securities are issued by dealers who pool assets
together, such as residential mortgages, commercial mortgages, and issue
claims that are backed by these assets.
We can also classify bonds by whether they are issued by a domes-

tic issuer or by a nondomestic, or foreign issuer. We can further classify theforeign issuers by the development of the ﬁnancial markets, into either devel-oped markets or emerging markets. Emerging markets are those in countries
that (1) have economies that are in transition but have started implement-
ing political, economic, and ﬁnancial market reforms in order to participatein the global capital market; (2) may expose investors to signiﬁcant price

volatility attributable to political risk and the unstable value of their cur-
rency; and (3) have a short period over which their ﬁnancial markets haveoperated.
We provide a classiﬁcation of bond investments in Exhibit 15.3. Though
other classiﬁcation schemes exist, this provides you with one possible wayof looking at bond investments.
Alternative Asset Classes With the exception of real estate, all of the asset
classes we have identiﬁed above are referred to as traditional asset classes.

Other investments are nontraditional asset classes oralternative asset classes.
These include hedge funds, private equity, and commodities.
Hedge funds are pools of investments, in which these investments are
wide-ranging. Because of their typically high-risk nature, the investment
in hedge funds is limited to professional investors and wealthy investors.Private equity investments are investments that provide the long-term equity

base of a company that is not listed on any exchange and consequently does
not have the ability to raise capital in the public stock market. Commodityinvestments are investments in the actual commodity or contracts based on
commodities ranging from agricultural products (such as corn, pork bellies,
and orange juice) to precious metals (such as gold and silver).

398 INVESTMENT MANAGEMENT
Bonds
Domestic
bonds
bondsMunicipal
bondsAsset-backed
bondsDeveloped
nationsEmerging
markets
and municipal
bondsResidential
mortgage-
backed securities
Other asset-
backed
securitiesCommerical
mortagage-
backed securitiesCorporate
bondsCorporate
bondsGovernment
bondsForeign
bonds
Corporate
bonds

bonds
Corporate
bonds
EXHIBIT 15.3 Classiﬁcation of Bond Investments
Investment Factors
In the development of an investment policy, client constraints, regulatory
constraints, and taxes must be considered.
Client-Imposed Constraints Examples of client-imposed constraints are
restrictions that specify the types of securities that a manager may invest and

concentration limits on how much or little may be invested in a particularasset class or in a particular issuer. Where the objective is to meet the
performance of a particular market or customized benchmark, there may
be a restriction as to the degree to which the manager may deviate fromsome key characteristics of the benchmark.
Regulatory Constraints Regulatory constraints involve constraints on the
asset classes that are permissible and concentration limits on investments.

Moreover, in making the asset allocation decision, the investment manager
must consider any risk-based capital requirements, which are present inportfolios managed for banking and insurance institutions. The amount of
statutory capital required for banking and insurance companies is related to

Investment Management 399
the quality of the assets in which the institution has invested.2As an example
of another type of regulatory constraint, regulated investment management
companies face restrictions on the amount of leverage they employ.3
Tax Considerations Tax considerations are important for several reasons.

First, certain institutional investors such as pension funds, endowments, and
foundations are exempt from federal income taxation. Consequently, the
asset classes in which they invest will not be those that are tax-advantagedinvestments. Second, there are tax factors that must be incorporated into the
investment policy. For example, while a pension fund might be tax-exempt,
there may be certain assets or the use of some investment vehicles in whichit invests whose earnings may be taxed.

Selecting a Portfolio Strategy
Another major activity in the investment management process is selecting aportfolio strategy consistent with the investment objectives and investmentpolicy guidelines of the client or institution. Portfolio strategies may be active
or passive strategies, or some blend of the two.
Anactive portfolio strategy uses available information and forecasting

techniques to seek a better performance than a portfolio that is simply di-versiﬁed broadly. Essential to all active strategies are expectations about the
factors that have been found to inﬂuence the performance of an asset class.In the case of active common stock strategies, this may include forecasts of
future earnings, dividends, or price-earnings ratios. With actively managed

bond portfolios, expectations may involve forecasts of future interest ratesand sector spreads. Active portfolio strategies involving foreign securities
may require forecasts of local interest rates and exchange rates.
Apassive portfolio strategy involves minimal expectations input, and
instead relies on diversiﬁcation to match the performance of some marketindex. In effect, a passive strategy assumes that the marketplace efﬁciently

reﬂects all available information in the price paid for securities.
Between these extremes of active and passive strategies, several strategies
have sprung up that have elements of both. For example, the core of aportfolio may be passively managed with the balance actively managed.
2Statutory capital is the amount of equity and equivalents that a company must have
to meet minimum regulatory standards. Risk-based capital standards specify that

the amount of capital needed as a minimum is based on the riskiness of the assets of
3Leverage in this context is borrowing funds in order to make investments.

400 INVESTMENT MANAGEMENT
A useful way of thinking about active versus passive management is in
terms of the three activities performed by the manager:
1.Portfolio construction (deciding on the stocks to buy and sell).
2.Trading of securities.
3.Portfolio monitoring.
Generally, active managers devote the majority of their time to portfolio

construction. In contrast, passive strategies managers devote less time to
this activity.
With bond investments, there are several strategies classiﬁed as struc-
tured portfolio strategies that are a type of liability-driven strategy. A struc-
tured portfolio strategy is one in which a portfolio is designed to achieve the
performance of some predetermined liabilities that must be paid out. Thesestrategies are frequently used when trying to match the funds received from

an investment portfolio to the future liabilities that must be paid and are
therefore liability-driven strategies.
Given the choice among active and passive management, which should
be selected? The answer depends on the:
1.Client’s or money manager’s view of how “price-efﬁcient” the market is.
2.Client’s risk tolerance.
3.Nature of the client’s liabilities.
As we discussed in Chapter 1, market price efﬁciency is how difﬁcult it

would be to earn a greater return than passive management after adjusting
for the risk associated with a strategy and the transaction costs associated
with implementing that strategy.
CONSTRUCTING AND MONITORING A PORTFOLIO
Once a portfolio strategy is selected, the investment manager must selectthe assets to be included in the portfolio. The investment management
process includes:
■Producing realistic and reasonable return expectations and forecasts.
■Constructing an efﬁcient portfolio.

■Monitoring, controlling, and managing risk exposure.
■Managing trades and transaction costs.
In seeking to produce realistic and reasonable return expectations, the
investment manager has several analytical tools available. An active port-
folio manager seeks to identify mispriced securities or market sectors. This

Investment Management 401
information is then used as inputs to construct an efﬁcient portfolio. An
efﬁcient portfolio is a portfolio that offers the greatest expected return for
a given level of risk or, equivalently, the lowest risk for a given expected
return.
Once a portfolio is constructed, the investment manager must moni-

tor the portfolio to determine how the portfolio’s risk exposure may havechanged given prevailing market conditions and information about the as-
sets in the portfolio. The current portfolio may no longer be efﬁcient and, asa result, the investment manager is likely to rebalance the portfolio in order
to produce an efﬁcient portfolio.
Transaction costs affect performance. The investment manager must

consider transactions costs not only in the initial construction of the portfo-lio, but when the portfolio is rebalanced.
MEASURING AND EVALUATING PERFORMANCE
The measurement and evaluation of investment performance involves two
activities. The ﬁrst activity is performance measurement which involvesproperly calculating the return realized by an investment manager over some
time interval, referred to as the evaluation period. The second activity is per-

formance evaluation, which is concerned with determining whether the in-
vestment manager added value by outperforming the established benchmark.
Measuring Performance
The starting point for evaluating the performance of an asset manager ismeasuring return. This might seem quite simple, but several practical is-sues make the task complex because we must take into account any cash
distributions made from a portfolio during the evaluation period.

Alternative Return Measures The dollar return realized on a portfolio for
any evaluation period (i.e., a year, month, or week) is equal to the sum of:
1.The difference between the market value of the portfolio at the end
of the evaluation period and the market value at the beginning of theevaluation period.
2.Any capital or income distributions from the portfolio to a client orbeneﬁciary of the portfolio.
Therate of return ,o rs i m p l yreturn , expresses the dollar return in terms

of the amount of the market value at the beginning of the evaluation period.

402 INVESTMENT MANAGEMENT
Thus, the return can be viewed as the amount (expressed as a fraction of the
initial portfolio value) that can be withdrawn at the end of the evaluationperiod while maintaining the initial market value of the portfolio intact.
We can express the portfolio’s return as
R
p=V1−V0+D
V0(15.1)
where: Rpis the return on the portfolio.

V0(15.1)
V1is the market value of the portfolio at the end of the evaluationperiod.
V
0is the market value of the portfolio at the beginning of theevaluation period.
Dis the cash distribution from the portfolio, if any, during the
evaluation period.
EXAMPLE 15.1: RETURN FOR A PERIOD
Consider a portfolio that begins the quarter with a market value of

$3 million, distributes $0.1 million to investors, and ends the quarterwith a market value of $3.2 million. What is the return on this portfolio
for this quarter?
Solution
R
p=$3.2 million +3.0 million +0.1 million
$3.0 million
When calculating the return on a portfolio in this manner we are making
three assumptions:
1.All cash inﬂows from dividends and interest during the evaluation period
are reinvested into the portfolio.

2.If there are distributions from the portfolio, they either occur at the end
of the evaluation period or are held in the form of cash until the end of
the evaluation period.
3.There are no cash contributions made after the start of the evaluation
period.

Investment Management 403
TRY IT! RETURN FOR A PERIOD
What is the return for each of the following periods?
PeriodValue at the
Beginning
Period DividendValue at the
End of the
Period
1 $10 $1 $9
2 $100 $5 $101
3 $1,000 $5 $1,100
Thus, while we can determine the return calculation for a portfolio us-
ing equation (15.1) for an evaluation period of any length of time (such

as one day, one month, or ﬁve years), from a practical point of view the
assumptions of this approach limit its application. Not only does the vio-
lation of the assumptions make it difﬁcult to compare the returns of twomoney managers over some evaluation period, but it is also not useful for
evaluating performance over different periods.
The way to handle these practical issues is to calculate the return for

a short unit of time such as a month or a quarter. We call the return socalculated the subperiod return. To get the return for the evaluation period,
the subperiod returns are then averaged. So, for example, if the evaluation
period is one year, and we calculate 12 monthly returns, the monthly returns
are the subperiod returns and we average these to get the one-year return. If

we want a three-year return, and we have available 12 quarterly returns, thequarterly returns are the subperiod returns, and we average these to get the
three-year return. For comparability with other investments, we will then
want to convert this three-year return into an annual return. For now, let’sfocus on calculating the subperiod return.
We can calculate an average of the subperiod returns using one of three
methodologies:
1.The arithmetic average rate of return

2.The time-weighted rate of return
3.The dollar-weighted return

404 INVESTMENT MANAGEMENT
We demonstrate and compare these averages using the following exam-
ple of the ABC Portfolio, with dollar amounts in millions:
End of Quarter Beginning Value Ending Value Return for the Quarter
Q1 $1.0 $1.5 50%
Q2 $1.5 $1.0 –33%
Q3 $1.0 $1.5 50%
Q4 $1.5 $1.0 –33%
Assume that there are no contributions to, nor withdrawals from, this

portfolio over these four quarters. What is the average quarterly return for
the ABC Portfolio?
Arithmetic Average Rate of Return Thearithmetic average rate of return ,
Ra, is an unweighted average of the subperiod returns:
Ra=R1+R2+R3+··· Rn
n=∑n
t=1Rt
n
where: Rais the arithmetic average return,
Rtis the return for period t,
nis the number of periods.
In our example, the arithmetic average quarterly return for the ABC
portfolio is
Ra=0.5−0.333 −0.5−0.333
4=8.333%

4=8.333%
This illustrates a major problem with using the arithmetic average rate
of return. To see this problem, consider that there were no contributions
to or cash withdrawals from this portfolio, and the portfolio’s value at
the end of the four quarters is exactly what it was to begin with. Yet the
arithmetic average rate of return is 8.333%. Not a bad return, consideringthat the portfolio’s value did not change. But think about this number. The

portfolio’s initial market value was $1 million. Its market value at the end
of four quarters is $1 million. The return over this four-month evaluationperiod is zero. Yet the arithmetic rate of return says it is 8.333%. Now you
can see why we do not use the arithmetic average in evaluating investment
performance.

Investment Management 405
Time-Weighted Rate of Return Thetime-weighted rate of return measures
the compounded rate of growth of the initial portfolio market value during
the evaluation period, assuming that all cash distributions are reinvestedin the portfolio. We also refer to this return as the geometric mean return

because it is computed by taking the geometric average of the portfoliosubperiod returns. The time-weighted rate of return, R
TW,i s
RTW=4√n∏
t=1(1+Rt)
In our example, the quarterly average time-weighted return is zero for
the ABC portfolio:
Rp=4√
(1+R1)(1+R2)(1+R3)(1+R4)−1
Rp=4√
(1.50)(0 .667)(1 .5)(0.667) −1=0%
EXAMPLE 15.2: TIME-WEIGHTED RATE OF RETURN
Consider portfolio returns of –10%, 20%, and 5% in July, August,

and September, respectively. What is the time-weighted monthly rateof return?
Solution
R
TW={[1+(−0.10)] (1 +0.20) (1 +0.05)}1/3−1
=[(0.90) (1 .20) (1 .05)]1/3−1
=0.043 or 4.3%
In other words, $1 invested in the portfolio at the beginning of July
would have grown at a rate of 4.3% per month during the three-month
In general, the arithmetic and time-weighted average returns produce

different values for the portfolio return. This is because in the arithmeticaverage rate of return calculation we assume that the amount invested is
maintained (through additions or withdrawals) at its initial portfolio mar-
ket value. In our example, the portfolio value changes each quarter. The

406 INVESTMENT MANAGEMENT
time-weighted return, on the other hand, is the return on a portfolio that
varies in size because of the assumption that all proceeds are reinvested.
Dollar-Weighted Rate of Return The dollar-weighted rate of return ,o r
themoney-weighted rate of return, is the rate of interest rate equates the

present value of the cash ﬂows from all the subperiods in the evaluation
period, including the terminal market value of the portfolio, to the initial
market value of the portfolio. The cash ﬂow for each subperiod reﬂects the
difference between the cash inﬂows due to investment income (i.e., dividends
and interest) and to contributions made by the client to the portfolio and

the cash outﬂows reﬂecting distributions to the client. Notice that it is notnecessary to know the market value of the portfolio for each subperiod to
determine the dollar-weighted rate of return.
The dollar-weighted rate of return is simply an internal rate of return
calculation. The dollar-weighted return, R
DW, solves the following:
V0=n∑
t=1CFt
(1+RDW)t+Vn
(1+RDW)n
where: CFtis the cash ﬂow for the portfolio (cash inﬂows minus cash
outﬂows) for subperiod t.

V0is the initial value of the portfolio.
Vnis the ending value of the portfolio.
EXAMPLE 15.3: DOLLAR-WEIGHTED RATE OF RETURN
Consider a portfolio with a market value of $100,000 at the beginningof July, capital withdrawals of $5,000 at the end of months July,August, and September, no cash inﬂows from the client in any month,
and a market value at the end of September of $110,000. What is the
dollar-weighted monthly rate of return?
Solution
$100, 000=$5,000

Solution
(1+RDW)1+$5,000
(1+RDW)2+$115, 000
(1+RDW)3

Investment Management 407
In terms of a ﬁnancial calculator or a spreadsheet, the cash ﬂows
are:
CF0=–$100,000
CF1=$5,000
CF2=$5,000
CF3=$115,000
The dollar-weighted return, calculated using a ﬁnancial calculator
or a spreadsheet, is 8.078%.
In the case of the ABC Portfolio, Vn=V0, so the dollar-weighted average
quarterly return, RDW,i s0 % :
$1.0=$1.0
(1+RDW)4

$1.0=$1.0
(1+RDW)4
The dollar-weighted rate of return and the time-weighted rate of return
produce the same result if no withdrawals or contributions over the evalu-
ation period, and if all of the portfolio’s cash inﬂows from dividends and
interest are reinvested. Therefore, for the ABC Portfolio, the time-weightedand dollar-weighted average quarterly returns are the same, 0%.
The problem with the dollar-weighted rate of return is that it is affected

by factors that are beyond the control of the investment manager. Specif-ically, any contributions made by the client or withdrawals that the client
requires affect the calculated dollar-weighted rate of return. This makes it
difﬁcult to compare the performance of two money managers or between aportfolio and its benchmark. To see how this works, consider the following
investment cash ﬂows for the DEF Portfolio, which are similar to the earlier

problem, but the investor invests an additional $1 million at the end of thesecond quarter and there are two distributions, one at the end of the third
quarter and one at the end of the fourth quarter:
Cash Flows
QuarterBeginning
ValueChange in
Market ValueCash
ContributionsCash
WithdrawalsEnding
Value
Q1 $1.0 $0.5 $1.5
Q2 $1.5 −$0.5 $1.0 $2.0
Q3 $2.0 $0.5 $0.5 $2.0
Q4 $2.0 −$0.5 $1.0 $0.5

408 INVESTMENT MANAGEMENT
The time-weighted average quarterly return for the DEF Portfolio is
17.02%:
End of Quarter Calculation Return
Q1 $0.5/$1.0 50.0%
Q2 (−$0.5) /$1.5 −33.3%
Q3 ($0.5 +0.5)/$2.0 50.0%
Q4 −($0.5 +1)/$2.0 25.0%
Average (1 +0.5)(1 – 0.333)(1 +0.5)(1 +0.25) 17.02%
Each quarter’s return requires comparing the change in value and any

withdrawals with the value of the portfolio at the beginning of the quarter.
The dollar-weighted average quarterly return for the DEF Portfolio
is 0%:
End of Quarter Type of Cash Flow Cash Flows
Q1 Initial investment –$1.0
Q2 Contribution –$1.0
Q3 Withdrawal +$0.5
Q4 Withdrawal, plus ending value +$1.5
We summarize the advantages and disadvantages of each method in
Exhibit 15.4. In general, we use the time-weighted average when we are

focusing on evaluating the portfolio manager, because this average is not
EXHIBIT 15.4 Advantages and Disadvantages to Alternative Rate of Return
Calculations
Type of
Average Advantages Disadvantages
Arithmetic
averageEasy to calculate Ignores compounding
Time weighted Not sensitive to cash
contributions and distributions
Considers compounding of
returns through timeRequires the market value
at the end of eachsubperiod
Dollar
weightedMakes intuitive sense as an
internal rate of return

No need to know value of
portfolio in each subperiodDistorted if there are cash
contributions or
distributions
Requires iterative process
to solve

Investment Management 409
affected by cash inﬂows and outﬂows of the portfolio that are often out-
side of the portfolio manager’s control. The time-weighted return, however,requires the market value of the investment at the end of each period. The
dollar-weighted average provides the average return on all funds invested in

the portfolio, which provides a good measure of the portfolio’s performanceif the portfolio manager has control over cash inﬂows and outﬂows of the
TRY IT! RETURNS
Consider a portfolio with a market value of $10 million at the begin-
ning of January, capital withdrawals of $1 million at the end of monthsJanuary, February, and March, no cash inﬂows from the client in any
month, and a market value at the end of September of $9 million.

a.What is the time-weighted monthly return on this portfolio?
b.What is the dollar-weighted monthly return on this portfolio?
Evaluating Performance
A performance measure does not answer two questions:
1.How did the asset manager perform after adjusting for the risk associ-
ated with the active strategy employed?
2.How did the asset manager achieve the reported return?
The answers to these two questions are critical in assessing how well

or how poorly the asset manager performed relative to some benchmark.
In answering the ﬁrst question, we must consider risk so that we can then
judge whether the performance was acceptable in the face of the risk.
The answer to the second question tells us whether the asset manager, in
fact, achieved a return by following the anticipated strategy. While a clientwould expect that any superior return accomplished is a result of a stated
strategy, this may not always be the case.

We brieﬂy describe methodologies for adjusting returns for risk so you
can analyze the return of a portfolio to uncover the reasons why a returnwas realized. We refer to this analysis as performance evaluation.
Single-Index Performance Evaluation Measures In the 1960s, several
single-index measures were used to evaluate the relative performance ofmoney managers. These measures of performance evaluation did not specify

410 INVESTMENT MANAGEMENT
how or why a money manager may have outperformed or underperformed
a benchmark. The three measures, or indexes, are the Treynor index, theSharpe index, and the Jensen index.
4All three measures assume that there is
a linear relationship between the portfolio’s return and the return on somebroad-based market index.

Performance Attribution Models In broad terms, we can explain an ac-
tively managed portfolio’s return performance by three types of actions of
the investment manager. The ﬁrst is actively managing a portfolio to capi-
talize on factors expected to perform better than other factors. The secondis actively managing a portfolio to take advantage of anticipated movements
in the market. For example, the manager of a common stock portfolio can

increase the portfolio’s beta when the market is expected to increase, anddecrease it when the market is expected to decline. The third is actively man-
aging the portfolio by buying securities that are believed to be undervalued,
and selling (or shorting) securities that are believed to be overvalued.
Attribution models evaluate the performance of a portfolio, attributing

a portfolio’s performance to style and selection. One of the key elements ofsuch models is to explain why a portfolio’s performance differed from that ofits benchmark. If the portfolio’s return differed from the benchmark, was this
due to asset allocation (that is, how much is allocated to each class)? How
much is due to the particular investment selection within the asset classes?

■The investment management process begins with the setting of invest-ment objectives, and then process with setting a policy, selecting a strat-
egy, constructing a portfolio, and then evaluating the performance of
the portfolio in the context of the investment objectives.
■The investment objectives of investors fall into two broad categories:liability-driven objectives and non-liability-driven objectives. A bench-mark is needed to evaluate the performance of an asset manager.

■The asset allocation decision involves determining how the portfolio’sinvestments should be distributed among the major asset classes. Thethree different types of asset allocation decisions are policy asset alloca-
tion, dynamic asset allocation, and tactical asset allocation.
4Jack Treynor, “How to Rate Management of Investment Funds,” Harvard Business
Review 44 (1965): 63–75; William F. Sharpe, “Mutual Fund Performance,” Journal

of Business 34 (1966): 119–138; and, Michael C. Jensen, “The Performance of
Mutual Funds in the Period 1945–1964,” Journal of Finance 23 (1968): 389–416.

Investment Management 411
■Investable investments are classiﬁed into asset classes based on the type
and risk associated with the investments’ cash ﬂows and value, legaland regulatory issues, and sensitivity to economic inﬂuences. The four
major asset classes are common stocks, bonds, cash equivalents, and

real estate. To create other asset classes, the four major asset classes canbe extended by, for example, separating foreign securities from domestic
securities. There are nontraditional asset classes (such as hedge funds)
that are referred to as alternative asset classes.
■In formulating an investment policy, client constraints, regulatory con-
straints, and taxes must be considered.
■Portfolio strategies may be active or passive strategies, or some blend

of the two. An active portfolio strategy uses available information and
forecasting techniques to seek a better performance than a portfolio that
is simply diversiﬁed broadly. A passive portfolio strategy involves min-
imal expectations input, and instead relies on diversiﬁcation to match
the performance of some market index.
■The selection of the speciﬁc assets to be included in a portfolio after the
portfolio strategy is selected involves producing realistic and reasonable

return expectations and forecasts; constructing an efﬁcient portfolio;monitoring, controlling; managing risk exposure; and managing trades
and transaction costs. An efﬁcient portfolio is a portfolio that offers the
greatest expected return for a given level of risk or, equivalently, thelowest risk for a given expected return.

■The measurement and evaluation of investment performance involvesperformance measurement (i.e., properly calculating the return realizedby an investment manager over the evaluation period) and performance
evaluation (i.e., determining whether the investment manager added
value by outperforming the established benchmark).
■Evaluating the performance of an investment portfolio requires estimat-
ing returns, adjusting for risk, and comparing the portfolio’s perfor-

mance against a benchmark portfolio’s performance.
Return for a Period
Period Solution
1 R=$9+1−10
$10=0%
2 R=$101+5−100
$100=6%
3 R=$1,100+5−1,000
$1,000=10.5%

412 INVESTMENT MANAGEMENT
Returns
a.RTW=[(1+0.10)(1 +0.10)(1 +0.00)]1/3−1=1.211/3−1=6.56%
b.$10=$1
(1+RDW)1+$1
(1+RDW)1+$1+9
(1+RDW)1;RDW=6.886%
QUESTIONS
1.What are the four major asset classes?
2.Distinguish between policy asset allocation and dynamic asset alloca-
tion.
3.What is meant by “market cap,” and how does this affect commonstock portfolio decisions?

4.What distinguishes a passive portfolio strategy from an active portfolio
strategy?
5.How does price efﬁciency inﬂuence the decision to pursue an active orpassive portfolio strategy?
6.What is the primary problem with the arithmetic average rate of return
in evaluating a portfolio’s performance?
7.If you want to evaluate the performance of a portfolio manager, which
would be more appropriate to use in calculating subperiod returns: the
dollar-weighted average or the time-weighted average? Why?

8.Consider a portfolio that has a value of $5 at the beginning of January,
with returns of –5%, 10%, and 10% in January, February, and March,
respectively. If there are no cash contributions or withdrawals during
the three months, what is the time-weighted average monthly rate ofreturn?
9.Consider a portfolio that has a value of $5 at the beginning of January,with returns of –5%, 10%, and 10% in January, February, and March,

the three months, what is the money-weighted average monthly rate ofreturn?
10.What is the purpose of a performance attribution model?
11.In terms of the price-to-book (P/B) ratio, why are value stocks generallyconsidered those with low P/B ratios?
12.Comment on the following statements:a.“All one needs to know about a portfolio manager’s ability is tocompare the return on the portfolio to the return on the benchmark.”

b.“By looking at the difference between the portfolio return and thereturn on a benchmark, one can determine how a portfolio managerwas able to outperform or underperform a benchmark.”

Investment Management 413
c.“In establishing an investment policy, investors should ignore any
liabilities and just select a market index that they want to outper-form.”
13.What type of constraints may a client impose on a portfolio manager?
14.If an investment in stock has a value of $3,000 at the beginning of theyear and $3,500 at the end of the year, and paid a dividend of $250 at

the end of the year, what is the return on the stock for the year?
15.Consider an investment with the following returns:
Year Return
15 %
2 −3%
34 %
45 %
What is the time-weighted annual return for this investment for the
four-year period?

414

c16 JWBT310-Fabozzi July 8, 2010 13:17 Printer: Courier Westford, Westford, MA
CHAPTER16
The Theory of Portfolio Selection
Throughout most of the history of stock markets—about
200 years in the United States and even longer in some European
countries—it never occurred to anyone to deﬁne risk with a
number. Stocks were risky and some were riskier than others, andpeople let it go at that. Risk was in the gut, not in the numbers.

For aggressive investors, the goal was simply to maximize return;
the faint-hearted were content with savings accounts andhigh-grade long-term bonds.
—Peter L. Bernstein, Against the Gods: The Remarkable Story
of Risk (New York: John Wiley & Sons, 1996), p. 247
In this chapter and the next, we set forth theories that are the underpinningsfor the management of portfolios: portfolio theory and capital market the-

ory. Portfolio theory deals with the selection of portfolios that maximizeexpected returns consistent with individually acceptable levels of risk. Usingquantitative models and historical data, portfolio theory deﬁnes “expected
portfolio returns” and “acceptable levels of portfolio risk,” and shows how
to construct an optimal portfolio. Capital market theory deals with the ef-fects of investor decisions on security prices. More speciﬁcally, it shows the

relationship that should exist between security returns and risk if investors
constructed portfolios as indicated by portfolio theory. Together, portfolioand capital market theories provide a framework to specify and measure in-
vestment risk and to develop relationships between expected security return
and risk (and hence between risk and required return on an investment).
The goal of portfolio selection is the construction of portfolios that

maximize expected returns consistent with individually acceptable levelsof risk. Using both historical data and investor expectations of future re-
turns, portfolio selection uses modeling techniques to quantify “expected
415

416 INVESTMENTS
portfolio returns” and “acceptable levels of portfolio risk,” and provides
methods to select an optimal portfolio. The theory allows investment man-agers to quantify the investment risk and expected return of a portfolio,
providing an objective complement to the subjective art of investment

management. More importantly, whereas at one time the focus of port-folio management used to be the risk of individual assets, the theory of
portfolio selection has shifted the focus to the risk of the entire portfolio.
This theory shows that it is possible to combine risky assets and produce aportfolio whose expected return reﬂects its components, but with the poten-
tial for considerably lower risk. In other words, it is possible to construct a

portfolio whose risk is less than the sum of all its individual parts.
In this chapter, we present the theory of portfolio selection as formulated
by Harry Markowitz.
1This theory is also referred to as mean-variance
portfolio analysis or simply mean-variance analysis. We also take a brief
look at behavioral ﬁnance, and how the theories formulated by proponentsof this ﬁeld of ﬁnance relate to investor choices.
SOME BASIC CONCEPTS

Portfolio theory draws on concepts from two ﬁelds: ﬁnancial economic the-ory and probability and statistical theory. This section presents the conceptsfrom ﬁnancial economic theory we use in portfolio theory. While many of
the concepts presented here have a more technical or rigorous deﬁnition,
the purpose is to keep the explanations simple and intuitive so the readercan appreciate the importance and contribution of these concepts to the

development of modern portfolio theory.
Utility Function and Indifference Curves
In life there are many situations where entities (i.e., individuals and ﬁrms)face two or more choices. The economic “theory of choice” uses the concept
of a utility function to describe the way entities make decisions when facedwith a set of choices. A utility function assigns a numeric value to all possible

choices faced by the entity. The higher the value of a particular choice, thegreater the utility derived from that choice. The choice that is selected is theone that results in the maximum utility given a set of (budget) constraints
faced by the entity.
1Harry M. Markowitz, “Portfolio Selection,” Journal of Finance 7 (1952): 77–91.

The Theory of Portfolio Selection 417
In portfolio theory too, entities are faced with a set of choices. Different
portfolios have different levels of expected return and risk. Also, the higher
the level of expected return is, the larger the risk. Entities are faced with
the decision of choosing a portfolio from the set of all possible risk–return

combinations: where return is a desirable that increases the level of utility,and risk is an undesirable that decreases the level of utility. Therefore, entities
obtain different levels of utility from different risk-return combinations. The
utility obtained from any possible risk–return combination is expressed bythe utility function. Put simply, the utility function expresses the preferences
of entities over perceived risk and expected return combinations.

A utility function can be expressed in graphical form by a set of indif-
ference curves. In Exhibit 16.1, we show indifference curves labeled u
1,u2,
andu3.By convention, the horizontal axis measures risk and the vertical
axis measures expected return. Each curve represents a set of portfolios withdifferent combinations of risk and return. All the points on a given indiffer-

ence curve indicate combinations of risk and expected return that will givethe same level of utility to a given investor. For example, on utility curve u
1,
there are two points, UandU′,w i t h Uhaving a higher expected return than
U′, but also having a higher risk. Because the two points lie on the same
indifference curve, the investor has an equal preference for (or is indifferent
to) the two points, or, for that matter, any point on the curve. The (positive)

slope of an indifference curve reﬂects the fact that, to obtain the same level
u1
u1u3Expected Return
Risku2
u2u3
U'U
EXHIBIT 16.1 Utility Functions and Indifference Curves

418 INVESTMENTS
of utility, the investor requires a higher expected return in order to accept
higher risk.
For the three indifference curves shown in Exhibit 16.1, the utility the

investor receives is greater the further the indifference curve is from thehorizontal axis, because that curve represents a higher level of return atevery level of risk. Thus, for the three indifference curves shown in the
exhibit, u
3has the highest utility and u1the lowest.
Efficient Portfolios and the Optimal Portfolio
Portfolios that provide the largest possible expected return for given levels
of risk are called efﬁcient portfolios. To construct an efﬁcient portfolio, it

is necessary to make some assumption about how investors behave whenmaking investment decisions. One reasonable assumption is that investorsarerisk averse. A risk-averse investor is an investor who, when faced with
choosing between two investments with the same expected return but twodifferent risks, prefers the one with the lower risk.
In selecting portfolios, an investor seeks to maximize the expected port-

folio return given his tolerance for risk. Alternatively stated, an investor seeksto minimize the risk that he is exposed to given some target expected return.
Given a choice from the set of efﬁcient portfolios, an optimal portfolio is
the one that is most preferred by the investor.
Risky Assets vs. Risk-Free Assets
A risky asset is one for which the return that will be realized in the future isuncertain. Common stock is considered a risky asset because of the uncer-

tainty about the future dividends and price when the investor wants to sellthe stock. The same is true for bonds because of the risk the issuer might
default.
There are assets, however, for which the return that will be realized
in the future is known with certainty today. Such assets are referred to asrisk-free orriskless assets. The risk-free asset is commonly deﬁned as a short-
term obligation of the U.S. government. For example, if an investor buys a

U.S. government security that matures in one year and plans to hold that
security for one year, then there is no uncertainty about the return that will
be realized. The investor knows that in one year, the maturity date of thesecurity, the government will pay a predetermined amount to retire the debt.
ESTIMATING A PORTFOLIO’S EXPECTED RETURN
We are now ready to deﬁne and measure the actual and expected return ofa risky asset and a portfolio of risky assets.

The Theory of Portfolio Selection 419
For a Single-Period Portfolio Return
The actual return on a portfolio of assets over some speciﬁc time period is
a weighted average of the returns on the individual assets in the portfolio,
and is straightforward to calculate using the following:
Rp=w1R1+w2R2+···+ wGRG (16.1)
where: Rpis the rate of return on the portfolio over the period,

Rgis the rate of return on asset gover the period,
wgis the weight of asset gin the portfolio (i.e., market value of
asset gis a proportion of the market value of the total portfolio)
at the beginning of the period, and
Gis the number of assets in the portfolio.
In shorthand notation, we can express equation (16.1) as
Rp=G∑
g=1wgRg (16.2)
In equation (16.2), the return on a portfolio, Rp,o fG assets is equal to
the sum over the products of the individual assets’ weights in the portfolio

and their respective return. The portfolio return Rpis sometimes called the
holding period return or the ex post return .
For example, consider the following portfolio consisting of three assets:
AssetMarket Value at
the Beginning of
the Holding PeriodHolding
Period
Return
1 $6 million 12%
2 8 million 10%
3 11 million 5%
Total $25 million
Restating this, using the proportion of the total market value for each asset:
Asset Proportion of Portfolio’s Market Value Holding Period Return

1 $6 million ÷$25 million =24% 12%
2 $8 million ÷$25 million =32% 10%
3 $11 million ÷$25 million =44% 5%

420 INVESTMENTS
Notice that the sum of the weights is equal to 1. Substituting into equa-
tion (16.1), we get the holding period portfolio return,
Rp=(0.24×0.12) +(0.32×0.10) +(0.44×0.05) =8.28%
The holding period portfolio return is 8.28%. Therefore, the growth in the
portfolio’s value in monetary terms over the holding period is $25 million×0.0828 =$2.07 million.

For a Portfolio of Risky Assets
In equation (16.1), we show how to calculate the actual return of a portfolioover some speciﬁc time period. In portfolio management, the investor alsowants to know the expected (or anticipated) return from a portfolio of risky
assets. In other words, the ex ante return. The expected portfolio return is
the weighted average of the expected return of each asset in the portfolio. The
weight assigned to the expected return of each asset is the percentage of the

market value of the asset to the total market value of the portfolio. That is,
E(R
p)=w1E(R1)+w2E(R2)+···+ wGE(RG) (16.3)
TheE( ) signiﬁes expectations, and E(R p) is the expected portfolio return
over some speciﬁc time period.
We calculate the expected return, E(R i), on a risky asset ias follows.
First, we specify the probability distribution for the possible rates of return
we expect to occur in the future period. A probability distribution is a func-

tion that assigns a probability of occurrence to all possible outcomes for a
random variable. Given the probability distribution, the expected value of
a random variable is simply the weighted average of the possible outcomes,where the weight is the probability associated with the possible outcome.
In our case, the random variable is the uncertain return of asset i.Hav-

ing speciﬁed a probability distribution for the possible rates of return, theexpected value of the rate of return for asset iis the weighted average of
the possible outcomes. Finally, rather than use the term “expected value ofthe return of an asset,” we simply use the term “expected return.” Mathe-matically, the expected return of asset iis expressed as
E(R
i)=p1R1+p2R2+···+ pNRN (16.4)
where: Rnis the nth possible rate of return for asset i.

pnis the probability of attaining the rate of return nfor asset i.
Nis the number of possible outcomes for the rate of return.

The Theory of Portfolio Selection 421
EXHIBIT 16.2 Probability Distribution for the Return for Asset XYZ and
Asset ABC
Possible
OutcomeReturn on
Asset XYZReturn on
Asset ABCProbability of
OccurrenceReturn on
Asset XYZ ×
ProbabilityReturn on
Asset ABC ×
Probability
1 12% 21% 18% 0.0216 0.0378
2 10 14 24 0.0240 0.0336
3 8 9 29 0.0232 0.0261
4 4 4 16 0.0064 0.0064
5 −4 −31 3 −0.0052 −0.0039

Total 100% 0.0700 0.1000
Expected return 7% 10%
In Exhibit 16.2 we provide the probability distribution for two hypo-
thetical assets, Asset XYZ and Asset ABC. The expected return for Asset
XYZ is 7% and the expected return for Asset ABC is 10%.
TRY IT! EXPECTED RETURN
What is the expected return for Asset Three and for Asset Four, giventhe following probability distributions?
PossibleOutcomeProbability of

Asset ThreeReturn on
Asset Four
1 25% 12% 21%
2 45% 10% 14%
3 30% 8% 9%
MEASURING PORTFOLIO RISK
The dictionary deﬁnes risk as “hazard, peril, exposure to loss or injury.”With respect to investments, investors have used a variety of deﬁnitions to
describe risk. Markowitz quantiﬁed the concept of risk using the well-known
statistical measures of variances and covariances. He deﬁned the risk of a

422 INVESTMENTS
portfolio as the sum of the variances of the investments and covariances
among the investments. The notion of introducing the covariances amongreturns of the investments in the portfolio to measure the risk of a portfolio
forever changed how the investment community thought about the concept
of risk.
Variance and Standard Deviation as a
Measure of Risk

Thevariance of a random variable is a measure of the dispersion or vari-
ability of the possible outcomes around the expected value.2In the case of
an asset’s return, the variance is a measure of the dispersion of the possible
rate of return outcomes around the expected return.
The equation for the variance of the expected return for asset i, denoted
σ2(Ri), is
σ2(Ri)=p1(r1−E(Ri))2+p2(r2−E(Ri))2+···+ pN(rN−E(Ri))2
(16.5)
assuming Npossible outcomes. This can also be expressed as

σ2(Ri)=N∑
n=1pn(rn−E(Ri))2
The variance associated with a distribution of returns measures the
compactness with which the distribution is clustered around the mean or
expected return. Markowitz argued that this variance is equivalent to the
uncertainty or riskiness of the investment. If an asset is riskless, it has anexpected return dispersion of zero. In other words, the return (which is also
the expected return in this case) is certain, or guaranteed.

Because the variance is in squared units, it is common to see the variance
converted to the standard deviation, σ, by taking the positive square root of
the variance:
σ(R
i)=√
σ2(Ri)
We provide the calculation of the standard deviation of the distribution
of the returns on Asset XYZ using this formula in Exhibit 16.3(Panel A).
Because expected return and variance are the only two parameters that
investors are assumed to consider in making investment decisions, we often

refer to the Markowitz formulation of portfolio theory as a two-parameter
2The expected value is the weighted mean of the probability distribution, where the
probabilities are the weights.

The Theory of Portfolio Selection 423
EXHIBIT 16.3 Standard Deviation of the Distribution of Returns for Asset XYZ
and Asset ABC
A. Asset XYZ
Possible
OutcomeReturn Less
Expected ReturnSquare of
DeviationProbability ×
Squared Deviation
1 0.0500 0.0025 0.0005
2 0.0300 0.0009 0.0002
3 0.0100 0.0001 0.0000
4 −0.0300 0.0009 0.0001
5 −0.1100 0.0121 0.0016
Variance = 0.0024

Standard deviation = 4.90%
B. Asset ABC
Possible
1 0.1100 0.0121 0.0022
2 0.0400 0.0016 0.0004
3 −0.0100 0.0001 0.0000
4 −0.0600 0.0036 0.0006
5 −0.1300 0.0169 0.0022
Variance = 0.0054
Standard deviation = 7.32%
model ormean-variance analysis. There have been models that propose
including additional measures of a return distribution into the portfolio
selection model.

TRY IT! STANDARD DEVIATION OF A DISTRIBUTION
What is the standard deviation of the following distribution of returnsfor Asset Five and Asset Six?
Possible
OutcomeProbability of
Asset FiveReturn on
Asset Six
1 25% 20% 25%
2 50% 10% 5%
3 25% −5% −15%

424 INVESTMENTS
Measuring the Portfolio Risk of a
Two-Asset Portfolio
In equation (16.5), we provide the variance for an individual asset’s return.
The variance of a portfolio consisting of two assets is a little more difﬁcult
to calculate. It depends not only on the variance of the two assets, but alsoupon how closely the returns of one asset track those of the other asset. The

formula for the variance of the portfolio is
σ
2(Rp)=w2
iσ2
i+w2
iσ2
i+2wiwjcov(Ri,Rj) (16.6)
where cov( Ri,Rj) is the covariance between the return for assets iandj.In
other words, the variance of the portfolio return is the sum of the squaredweighted variances of the two assets, plus two times the weighted covariance
between the two assets. We can generalize this equation to the case wheremore than two assets are in the portfolio.
Covariance

Like the variance, the covariance has a precise mathematical translation. Its
practical meaning is the degree to which the returns on two assets covary
or change together. In fact, the covariance is just a generalized concept ofthe variance applied to multiple assets. A positive covariance between two
assets means that the returns on two assets tend to move or change in the

same direction, while a negative covariance means the returns tend to movein opposite directions. The covariance between any two assets iandjis
computed using the following formula:
cov(R
i,Rj)=p1[
(ri1−E(Ri))(
rj1−ER j)]
+p2[
(ri2−E(Ri))(
rj2−ER j)]
+···
+pN[
(riN−E(Ri))(
rjN−ER j)](16.7)
where: rinis the nth possible rate of return for asset i.
rjnis the nth possible rate of return for asset j.
pnis the probability of attaining the rate of return nfor assets i
andj.

andj.
Thecorrelation between the returns for assets iandj, denoted by ρi,j
is the covariance of the two assets divided by the product of their standard
deviations:
ρi,j=cov(Ri,Rj)
σiσj(16.8)

The Theory of Portfolio Selection 425
EXHIBIT 16.4 Calculation of Covariance and Correlation between Assets iandj
Possible
Outcome ProbabilityDeviation for
Asset XYZ
(riXYZ−E(RXYZ))Deviation for
Asset ABC
(riABC−E(RABC))Product of the
Deviations and
1 18% 0.0500 0.1100 0.0010
2 24% 0.0300 0.0400 0.0003
3 29% 0.0100 −0.0100 0.0000
4 16% −0.0300 −0.0600 0.0003

5 13% −0.1100 −0.1300 0.0019
Covariance = 0.0034
Correlation = 0.9441
The correlation coefﬁcient can have values ranging from +1.0, denot-
ing perfect comovement in the same direction, to –1.0, denoting perfect
co-movement in the opposite direction. Because standard deviations are al-
ways positive, the correlation can only be negative if the covariance is a neg-
ative number. A correlation of zero implies that the returns are uncorrelated.

The correlation and the covariance are conceptually similar terms, yet
scaled differently. The correlation between two random variables is the co-variance divided by the product of their standard deviations. Because the
correlation is a standardized number (i.e., it has been corrected for differ-
ences in the standard deviation of the returns), the correlation is comparableacross different assets.
The correlation between the returns for Asset XYZ and Asset ABC is

0.9441. We provide the details of this calculation in Exhibit 16.4.
TRY IT! CORRELATION AND COVARIANCE
Complete the following table:
PortfolioStandard
Deviation of
Asset One’s
ReturnsStandard
Asset Two’s
ReturnsCorrelation of
the Returns of
Asset One and
Asset TwoCovariance of
Asset Two
1 20% 30% 0.030
2 20% 0.200 0.020
3 60% 30% −0.500
4 25% 0.250 0.016
5 40% 20% 0.064

426 INVESTMENTS
Measuring the Risk of a Portfolio Comprised of
More than Two Assets
So far we have deﬁned the risk of a portfolio consisting of two assets. The
extension to three assets— i,j, and k—is as follows:
σ2(
Rp)
=w2
iσ2(Ri)+w2
jσ2(
Rj)
+w2
kσ2(Rk)+2wiwjcov(RiRj)
+2w iwkcov(RiRk)+2wjwkcov(RjRk) (16.9)
In words, equation (16.9) states that the variance of the portfolio return

is the sum of the squared weighted variances of the individual assets plus
two times the sum of the weighted pairwise covariances of the assets. In
general, for a portfolio with Gassets, the portfolio variance is given by
σ2(
Rp)
=G∑
g=1G∑
h=1wgwhcov(RgRh) (16.10)
In equation (16.10), the terms for which h=gresults in the variances
of the Gassets, and the terms for which h̸=gresults in all possible pairwise
covariances amongst the Gassets. Therefore, equation (16.10) is shorthand

notation for the sum of all Gvariances and the possible covariances amongst
theGassets.
PORTFOLIO DIVERSIFICATION
Often, one hears investors talking about diversifying their portfolio. An
investor who diversiﬁes constructs a portfolio in such a way as to reduce
portfolio risk without sacriﬁcing return. This is certainly a goal that investorsshould seek. However, the question is how to do this in practice. A major
contribution of the theory of portfolio selection is that by using the concepts

discussed above, we can quantify the diversiﬁcation of a portfolio, and it isthis measure that investors can use to achieve the maximum diversiﬁcation
beneﬁts.
The Markowitz diversiﬁcation strategy is primarily concerned with the
degree of covariance between asset returns in a portfolio. Indeed a keycontribution of Markowitz diversiﬁcation is the formulation of an asset’s

risk in terms of a portfolio of assets, rather than in isolation. Markowitzdiversiﬁcation seeks to combine assets in a portfolio with returns that are
less than perfectly positively correlated, in an effort to lower portfolio risk
(variance) without sacriﬁcing return. It is the concern for maintaining return,

The Theory of Portfolio Selection 427
while lowering risk through an analysis of the covariance between asset
returns, that separates Markowitz diversiﬁcation from a naive approach todiversiﬁcation and makes it more effective.
We illustrate Markowitz diversiﬁcation and the importance of asset

correlations with a simple two-asset portfolio example. To do this, we ﬁrstshow the general relationship between the risk of a two-asset portfolio and
the correlation of returns of the component assets. Then we look at the
effects on portfolio risk of combining assets with different correlations.
Portfolio Risk and Correlation
In our two-asset portfolio, assume that Asset C and D are available with
expected returns and standard deviations of:
Asset E(R) σ(R)
Asset C 12% 30%Asset D 18% 40%

If an equal 50% weighting is assigned to both Asset C and D, the
expected portfolio return using equation (16.1) is 15% and the variance of
the return on the two-asset portfolio from equation (16.6) is
σ
2(Rp)=[0.52×0.32]+[0.52×0.42]+[2×0.52×0.52×cov(RC,RD)]
Using the relation between the covariance and the standard deviations
of the two securities from equation (16.8),
ρC,D=cov(RC,RD)
σCσD(16.11)
so
cov(RC,RD)=σ(RC)σ(RD)ρ(RC,RD)

so
Because σ(RC)=30% and σ(RD)=40%, then
cov(RC,RD)=(30% ×40%) ρ(RC,RD)=0.12ρ(RC,RD)
Substituting into the expression for σ2(Rp), we get
σ2(Rp)=[0.52×0.32]+[0.52×0.42]+[2×0.5×0.5×0.12ρ(RC,RD)]

428 INVESTMENTS
Therefore,
σ2(Rp)=0.0225 +0.04+0.06ρ(RC,RD)
Multiplying and taking the square root of the variance gives
σ(
Rp)
=√
0.0625 +(0.06ρ(RCRD))
Let’s look at our two-asset portfolio with different correlations between
the returns of the component assets. Speciﬁcally, consider the following three
cases for ρ(RC,RD):+1.0, 0, and –1.0. Substituting into equation (16.11)

for these three cases of ρ(RC,RD), we get the following:
Correlation E(R p)σ(Rp)
+1.0 15% 35%
0.0 15% 25%
–1.0 15% 5%
As the correlation between the expected returns on Asset C and Asset D
decreases from +1.0 to 0.0 to –1.0, the standard deviation of the expected
portfolio return also decreases from 35% to 5%. However, the ex-pected portfolio return remains 15% for each case.
This is an example of Markowitz diversiﬁcation. The principle of

Markowitz diversiﬁcation is that as the correlation between the returns
for assets that are combined in a portfolio decreases, so does the variance
(hence the standard deviation) of the return for the portfolio.
In choosing a portfolio, investors should seek broad diversiﬁcation.
Further, they should understand that equities—and corporate bonds
also—involve risk; that markets inevitably ﬂuctuate, and the port-folio should be such that they are willing to ride out the bad as well

as the good times.
—Harry Markowitz, October 7, 2008
CHOOSING A PORTFOLIO OF RISKY ASSETS
Diversiﬁcation in the manner suggested by Markowitz leads to the construc-
tion of portfolios that have the highest expected return at a given level of

The Theory of Portfolio Selection 429
risk. We refer to such portfolios as efﬁcient portfolios. In order to construct
efﬁcient portfolios, the theory makes some basic assumptions about asset
selection behavior by investors. The assumptions are as follows:

1.The only two parameters that affect an investor’s decision are the ex-pected return and the variance. (That is, investors make decisions usingthe two-parameter model formulated by Markowitz.)
2.Investors are risk averse. That is, when faced with two investments withthe same expected return but two different risks, investors will preferthe one with the lower risk.
3.All investors seek to achieve the highest expected return at a given levelof risk.

4.All investors have the same expectations regarding expected return,variance, and covariances for all risky assets. This assumption is referredto as the homogeneous expectations assumption.
5.All investors have a common one-period investment horizon.
Constructing Efficient Portfolios
The technique of constructing efﬁcient portfolios from large groups of as-
sets requires a massive number of calculations. For a portfolio of just 50

securities, there are 1,224 covariances that must be calculated. For 100securities, there are 4,950. Furthermore, in order to solve for the portfo-
lio that minimizes risk for each level of return, a mathematical technique
called quadratic programming must be used. A discussion of this tech-
nique is beyond the scope of this chapter. However, it is possible to illustrate
the general idea of the construction of efﬁcient portfolios by referring again

to the simple two-asset portfolio consisting of Assets C and D.
Recall that for these two assets,
E(R
C)=12% and σ(RC)=30%
E(RD)=18% and σ(RD)=40%
Now further assume that ρ(RC,RD)=–0.5. We provide the expected
portfolio return and standard deviation for ﬁve different portfolios made upof varying proportions of C and D in Exhibit 16.5. As you can see in Panel A
of Exhibit 16.5, the mix of 50–50 for C and D in the portfolio results in the

lowest standard deviation of the ﬁve mixes. In Panel B of Exhibit 16.5, weshow the portfolio standard deviation for a wider range of mixes of Asset C
and D, you can see that the portfolio’s standard deviation is lowest around
60% Asset C and 40% Asset D.

430 INVESTMENTS
A. Portfolio standard deviation for five different mixes 
    of Asset C and Asset D
MixWeight
of CWeight
of DExpected
return VarianceStandard
deviation
1 100% 0% 12.00% 0.09000 30.00%
2 75% 25% 13.50% 0.03813 19.53%
3 50% 50% 15.00% 0.03250 18.03%4 25% 75% 16.50% 0.07313 27.04%
5 0% 100% 18.00% 0.16000 40.00%
B. Portfolio standard deviation for weights of Asset C

from 100% to 0%
0%10%20%30%40%50%
100% 85% 70% 55% 40% 25% 10%
Percent Invested in Asset CPortfolio Standard Deviation
EXHIBIT 16.5 Portfolio Expected Return and Standard Deviation
for a Portfolio Comprised of Asset C and D
Feasible and Efficient Portfolios
Afeasible portfolio is any portfolio that an investor can construct given the
assets available. The ﬁve portfolios presented in Exhibit 16.5 are all feasible

portfolios. The collection of all feasible portfolios is called the feasible set
of portfolios. With only two assets, the feasible set of portfolios is graphed
as a curve that represents those combinations of risk and expected returnthat are attainable by constructing portfolios from all possible combinations
of the two assets. In Panel B of Exhibit 16.5, we show the feasible set ofportfolios for all combinations of assets C and D.

In contrast to a feasible portfolio, an efﬁcient portfolio is one that gives
the highest expected return of all feasible portfolios with the same risk.An efﬁcient portfolio is also said to be a mean-variance efﬁcient portfolio.
Thus, for each level of risk there is an efﬁcient portfolio. The collection ofall efﬁcient portfolios is called the efﬁcient set.

The Theory of Portfolio Selection 431
Expected Return
Standard Devia/g415on
EXHIBIT 16.6 Efﬁcient Portfolios with Assets C and D
We provide the efﬁcient set for the feasible set presented in Exhibit 16.6.
Efﬁcient portfolios are the combinations of Assets C and D that result in
the risk–return combinations on the curve from Portfolio 3 to 5. These

portfolios offer the highest expected return at a given level of risk. Notice
that Portfolios 1 and 2 are not included in the efﬁcient set. This is becausethere is at least one portfolio in the efﬁcient set (for example, Portfolio 3)
that has a higher expected return and lower risk than both of them.
We can also see that Portfolio 4 has a higher expected return and lower

risk than Portfolio 1. In fact, the whole curve section 1–3 is not efﬁcient. Forany given risk-return combination on this curve section, there is a combina-
tion (on the curve section 3–5) that has the same risk and a higher return, orthe same return and a lower risk, or both. In other words, for any portfolio
that results in the return-risk combination on the curve section 1–3 (exclud-
ing Portfolio 3), there exists a portfolio that dominates it by having the same

return and lower risk, or the same risk and a higher return, or a lower risk
and a higher return. For example, Portfolio 4 dominates Portfolio 1, andPortfolio 3 dominates both Portfolio 1 and 2.
In Exhibit 16.7 we illustrate the feasible and efﬁcient sets when there are
more than two assets. In this case, the feasible set is not a curve, but ratheran area. This is because, unlike the two-asset case, it is possible to create

asset portfolios that result in risk–return combinations that not only result
in combinations that lie on the curve I–II–III, but all combinations that liein the shaded area. However, the efﬁcient set is given by the curve II–III. It is
easily seen that all the portfolios on the efﬁcient set dominate the portfolios
in the shaded area.

432 INVESTMENTS
RiskIII
III
EXHIBIT 16.7 Feasible and Efﬁcient Portfolios with More
Than Two Assets
We sometimes refer to the efﬁcient set of portfolios as the efﬁcient
frontier, because graphically all the efﬁcient portfolios lie on the boundary
of the set of feasible portfolios that have the maximum return for a given

level of risk. Any risk–return combination above the efﬁcient frontier cannot
be achieved, while risk–return combinations of the portfolios that make up
the efﬁcient frontier dominate those that lie below the efﬁcient frontier.
Choosing the Optimal Portfolio in the Efficient Set
Now that we have constructed the efﬁcient set of portfolios, the next step is
to determine the optimal portfolio.
Because all portfolios on the efﬁcient frontier provide the greatest pos-

sible return at their level of risk, an investor or entity will want to hold oneof the portfolios on the efﬁcient frontier. Notice that the portfolios on the
efﬁcient frontier represent trade-offs in terms of risk and return. Movingfrom left to right on the efﬁcient frontier, the risk increases, but so does the
expected return. The question is which one of those portfolios should an
investor hold? The best portfolio to hold of all those on the efﬁcient frontieris the optimal portfolio.

Intuitively, the optimal portfolio should depend on the investor’s prefer-
ence over different risk-return trade-offs. As explained earlier, this preferencecan be expressed in terms of a utility function.

The Theory of Portfolio Selection 433
u1
Risku2
u2u3
Efficient
frontier
Optimal
portfolio
EXHIBIT 16.8 Selecting the Optimal Portfolio
We drew the three indifference curves representing a utility function
and the efﬁcient frontier in Exhibit 16.8, drawn on the same diagram. An
indifference curve indicates the combinations of risk and expected return

that give the same level of utility. Moreover, the farther the indifference
curve from the horizontal axis, the higher the utility.
From Exhibit 16.8, we can determine the optimal portfolio for the in-
vestor with these indifference curves. Remember that the investor wantsto get to the highest indifference curve achievable given the efﬁcient fron-tier. Given that requirement, the optimal portfolio is represented by the
point where an indifference curve is tangent to the efﬁcient frontier. In

Exhibit 16.8, that is the portfolio.
Consequently, for the investor’s preferences over risk and return as de-
termined by the shape of the indifference curves represented in Exhibit 16.8.If this investor prefers more return and less risk, the optimal portfolio is as
indicated in Exhibit 16.8: at the point of tangency of the efﬁcient frontier
and utility curve u
2. If this investor had a different preference for expected
risk and return, there would have been a different optimal portfolio.

At this point in our discussion, a natural question is how to estimate
an investor’s utility function so that the indifference curves and, hence, theoptimal portfolio can be determined. Unfortunately, there is little guidance
about how to construct one. In general, economists have not been successful
in estimating utility functions. The inability to estimate utility functionsdoes not mean that the theory is ﬂawed. What it does mean is that once

an investor constructs the efﬁcient frontier, the investor will subjectively
determine that efﬁcient portfolio is appropriate given his or her toleranceto risk.

434 INVESTMENTS
ISSUES IN THE THEORY OF PORTFOLIO SELECTION
The theory of portfolio selection set forth by Markowitz was based on some
modeling assumptions regarding the behavior of investors when making
investment decisions and about the probability distribution of the return on

assets that made it acceptable to use the variance or standard deviation asa measure of risk. Moreover, in terms of implementation of the portfolio
selection model that relied on the estimation of inputs from historical data,
no consideration was given to the implications of what happens if a portfoliomanager misestimates the inputs required by the model: expected returns,
variances, and covariances of returns.
In this section, we look at the issues surrounding the theory of portfolio

selection and the implementation of the model.
Alternative Risk Measures for Portfolio Selection
If the return distribution is normally distributed, then the variance is a use-
ful measure of risk. The normal distribution is a symmetric distribution so
outcomes above and below the expected value are equally likely. However,
there are both empirical studies of real-world ﬁnancial markets as well astheoretical arguments that suggest that we should reject the normal distri-
bution assumption.
3

3
Markowitz considered the problems associated with using the variance
of returns as a measure of investment risk. In fact, he recognized that an
alternative to the variance is the semivariance. The semivariance is similar
to the variance except that in the calculation no consideration is given to
returns above the expected return. Portfolio selection could be recast in terms

of mean-semivariance. However, if the return distribution is symmetric,Markowitz argues that both the variance and the semivariance produce
similar decisions, and that, further, the variance is a more familiar statistic
than the semivariance.
4,5
3For a review of the empirical evidence, see Svetlozar T. Rachev, Christian Menn, and
Frank J. Fabozzi, Fat-Tailed and Skewed Asset Return Distributions: Implications
for Risk Management, Portfolio Selection, and Option Pricing (Hoboken, NJ: John

Wiley & Sons, 2005).
4Harry M. Markowitz, Portfolio Selection: Efﬁcient Diversiﬁcation of Investment
(New York: John Wiley & Sons, 1959), 190, 193–194.
5The mean and the variance are the ﬁrst two moments of a probability distribution.
The third moment is a measure of skewness and the fourth moment is a measure
of kurtosis. A generalization of the mean-variance framework that incorporateshigher moments, such as skewness and kurtosis, has been developed. Because of the

technical complexity of these models, we do not discuss them here.

The Theory of Portfolio Selection 435
There is debate on the best risk measures to use for optimizing an
investor’s portfolio. According to the literature on portfolio theory, two dis-
jointed categories of risk measures can be deﬁned: dispersion measures and
safety-risk measures. We describe some of the most well-known dispersion
measures and safety-ﬁrst measures next.

VARIANCE VS. SEMIVARIANCE
The variance of a probability distribution, σ2,i s
σ2=N∑
n=1pn(xn−E(x))2
The semivariance, σ2
S, is calculated using only those observations
below the expected value:
σ2
S=N∑
for n if x n<E(x)pn(xn−E(x))2
Dispersion Measures The variance or standard deviation (more techni-
cally referred to as the mean-standard deviation ) is a dispersion measure.

There are several different measures of dispersion available. The mostcommonly used measure (and easiest to understand) is the mean-absolutedeviation.
Themean-absolute deviation (MAD) dispersion measure is based on the
absolute value of the deviations from the mean rather than the squared de-viations as in the case of the mean-standard deviation. Whereas the variance
is affected by outliers, especially because of the squaring of deviations from
the mean, the MAD is less affected by outliers.

Safety-First Risk Measures Many suggest safety-ﬁrst rules as a criterion
for decision making under uncertainty.
6In these models, a subsistence, a
6See, among others, Andrew D. Roy, “Safety-First and the Holding of Assets,”
Econometrica 20 (1952): 431–449; Lester G. Tesler, “Safety First and Hedging,”
Review of Economic Studies 23 (1955/1956): 1–16; Vijay S. Bawa, “Admissi-

ble Portfolio for All Individuals,” Journal of Finance 31 (1976): 1169–1183; and
Vijay S. Bawa, “Safety-First Stochastic Dominance and Optimal Portfolio Choice,”
Journal of Financial and Quantitative Analysis 13 (1978): 255–271.

436 INVESTMENTS
benchmark, or a disaster level of returns is identiﬁed. The objective is the
maximization of the probability that the returns are above the benchmark.Thus, most of the safety-ﬁrst risk measures proposed in the literature are
linked to the benchmark-based approach.
Some of the most well-known safety-ﬁrst risk measures proposed in the
literature are:
■Classical safety-ﬁrst

■Value at risk
■Conditional value at risk/expected tail loss
■Lower partial moment
In the classical safety-ﬁrst portfolio choice problem, the risk measure is
the probability of loss or, more generally, the probability of portfolio return
less than some speciﬁed value.7In terms of implementation, generally, this
approach requires solving a much more complex optimization problem to
ﬁnd the optimal portfolios in contrast to the mean-variance model.

Probably the most well-known downside risk measure is value at risk
(VaR). This measure is related to the percentiles of loss distributions, andmeasures the predicted maximum loss at a speciﬁed probability level (for
example, 95%) over a certain time horizon (for example, 10 days). The
main characteristic of VaR is that of synthesizing in a single value the pos-sible losses that could occur with a given probability in a given temporal

horizon. This feature, together with the very intuitive concept of maximum
probable loss, allows investors to ﬁgure out how risky a portfolio or tradingposition is. There are various ways to calculate the VaR of a security or
a portfolio but a discussion of these methodologies is beyond the scope of
this book.
Despite the advantages cited for VaR as a measure of risk, it does have

several theoretical limitations. Speciﬁcally, it ignores returns beyond the VaR(i.e., it does not consider the concentration of returns in the tails beyond
VaR). To overcome these limitations and problems, the conditional value at
risk(CVaR) has been suggested as an alternative risk measure. CVaR, which
we also refer to as the expected shortfall orexpected tail loss, measures the
expected value of portfolio returns, given that the VaR has been exceeded.

A natural extension of semivariance is the lower partial moment
risk measure.
8This measure, also called downside risk, depends on two
7See Roy, “Safety-First and the Holding of Assets.”
8See Bawa, “Admissible Portfolio for All Individuals”; and Peter C. Fishburn, “Mean-
risk Analysis with Risk Associated with Below-Target Returns,” American Economic
Review 67 (1977): 116–126.

The Theory of Portfolio Selection 437
parameters: (1) a power index, which is a proxy for the investor’s degree of
risk aversion; and (2) the target rate of return, which is the minimum returnthat must be earned.
Though the mathematics of these measures are complex, the bottom line

is that measures exist that investors can use in addition to the mean-varianceanalysis to assist in the construction of a portfolio.
Robust Portfolio Optimization Despite the inﬂuence and theoretical impact
of modern portfolio theory, today—almost 60 years after Markowitz’s sem-
inal work—full risk–return optimization at the asset level is primarily doneonly at the more quantitatively-oriented asset management ﬁrms. The avail-

ability of quantitative tools is not the issue—today’s optimization technology
is mature and much more user-friendly than it was at the time Markowitzﬁrst proposed the theory of portfolio selection—yet many asset managers
avoid using the quantitative portfolio allocation framework altogether.
A major reason for the reluctance of portfolio managers to apply quanti-

tative risk–return optimization is that they have observed that it may be un-reliable in practice. Speciﬁcally, mean-variance optimization (or any measure
of risk for that matter) is very sensitive to changes in the inputs. In the caseof mean-variance optimization, such inputs include the expected return, the
variance of each asset, and the asset covariance between each pair of assets.
While it can be difﬁcult to make accurate estimates of these inputs,

estimation errors in the forecasts signiﬁcantly affect the resulting portfolio
weights. As a result, the optimal portfolios generated by the mean-varianceanalysis generally have extreme or counterintuitive weights for some as-
sets.
9Such examples, however, are not necessarily a sign that the theory of
portfolio selection is ﬂawed; rather that, when used in practice, the mean-
variance analysis as presented by Markowitz has to be modiﬁed in order

to achieve reliability, stability, and robustness with respect to model and
estimation errors.
It goes without saying that advances in the mathematical and physical
sciences have had a major impact upon ﬁnance. In particular, mathematicalareas such as probability theory, statistics, econometrics, operationsresearch, and mathematical analysis have provided the necessary tools and
discipline for the development of modern ﬁnancial economics. Substantial

9See Michael J. Best and Robert R. Grauer, “On the Sensitivity of Mean-Variance
Efﬁcient Portfolios to Changes in Asset Means: Some Analytical and Computational
Results,” Review of Financial Studies 4 (1991): 315–342; Mark Broadie, “Comput-
ing Efﬁcient Frontiers Using Estimated Parameters,” Annals of Operations Research
45 (1993): 21–58; and Vijay K. Chopra and William T. Ziemba, “The Effects ofErrors in Means, Variances, and Covariances on Optimal Portfolio Choice,” Jour-

438 INVESTMENTS
advances in the areas of robust estimation and robust optimization were
made during the 1990s, and have proven to be of great importance forthe practical applicability and reliability of portfolio management and
optimization.
Any statistical estimate is subject to error—estimation error. A robust

estimation is a statistical estimation technique that is less sensitive to out-liers in the data. For example, in practice, it is undesirable that one or a few
extreme returns have a large impact on the estimation of the average returnof a stock. Nowadays, statistical techniques such as Bayesian analysis and
robust statistics are more commonplace in asset management. Taking it one

step further, practitioners are starting to incorporate the uncertainty intro-duced by estimation errors directly into the optimization process. This is
very different from traditional mean-variance analysis, where one solves the
portfolio optimization problem as a problem with deterministic inputs (i.e.,
inputs that are assumed to be known with certainty), without taking the esti-

mation errors into account. In particular, the statistical precision of individ-ual estimates is explicitly incorporated into the portfolio allocation process.
Providing this beneﬁt is the underlying goal of robust portfolio optimization.
BEHAVIORAL FINANCE AND PORTFOLIO THEORY
In building economic models, ﬁnancial economists make assumptions about
the behavior of those who make investment decisions in ﬁnancial markets.We refer to these entities as economic agents. More speciﬁcally, they make

assumptions about how economic agents make investment choices in select-ing assets to include in their portfolio.
The underlying economic theory that ﬁnancial economists draw upon in
formulating various theories of choice is utility theory. There are concernswith the reliance on such theories. Prominent economists, such as John May-
nard Keynes, have argued that investor psychology affects security prices.

Support for this view came in the late 1970 when two psychologists, DanielKahneman and Amos Tversky, demonstrated that the actions of economic
agents in making investment decisions under uncertainty are inconsistent
with the assumptions made by ﬁnancial economists in formulating ﬁnancialtheories.
10
Based on numerous experiments, Kahneman and Tversky attacked util-
ity theory and presented their own view as to how investors made choices

10See Daniel Kahneman and Amos Tversky, “Advances in Prospect Theory: Cumu-
lative Representation of Uncertainty,” Journal of Risk and Uncertainty 5 (1992):
297–323.

The Theory of Portfolio Selection 439
under uncertainty that they called prospect theory. Prospect theory focuses
on decision-making under uncertainty, describing behavior as involving a
heuristic.11First, individuals consider the possible investments and decide
which ones are similar and which ones are different. Second, individuals

evaluate the possible outcomes and probabilities, selecting the investment
based on decision weighting, such that these weights do not necessarily re-late to probabilities. An important contribution of the work of Kahneman
and Tversky is that they argue that individuals behave differently regarding
gains and losses. This is in contrast to the mean-variance theories that usevariance, which assumes investors view gains and losses as symmetric.

Other attacks on the assumptions of traditional ﬁnancial theory drawing
from the ﬁeld of psychology lead to the specialized ﬁeld in ﬁnance knownas behavioral ﬁnance.
12Behavioral ﬁnance looks at how psychology affects
investor decisions and the implications not only for the theory of portfolioselection, but in deriving a theory about asset pricing.
The foundations of behavioral ﬁnance have the following three behav-
ioral themes:
13

13
Theme 1: When making investment decisions, investors make errors
because they rely on rules of thumb.
Theme 2: Investors are inﬂuenced by form as well as substance in making
investment decisions.
Theme 3: Prices in the ﬁnancial market are affected by errors and deci-
sion frames.
11“Prospect theory” does not relate to prospecting. As related by Peter Bernstein in
his book Against the Gods: The Remarkable Story of Risk (New York: John Wiley &

Sons, 1996), Kahneman states, “We just wanted a name that people would notice
and remember.”
12For a further discussion of behavioral ﬁnance, see the following chapters in Frank
J. Fabozzi (ed.), Handbook of Finance, vol. 2 (Hoboken, NJ: John Wiley & Sons,
2008): Meir Statman, Chapter 9, “What Is Behavioral Finance”; Jarrod W. Wilcox,Chapter 8, “Behavioral Finance”; Victor Ricciardi, Chapter 10, “The Psychology ofRisk: The Behavioral Finance Perspective”; and Frank J. Fabozzi (ed.), Handbook

of Finance, vol. 2 (Hoboken, NJ: John Wiley & Sons, 2008): Victor Ricciardi,
Chapter 2, “Risk: Traditional Finance versus Behavioral Finance.”
13These themes are from Hersh Shefrin, Beyond Greed and Fear: Understanding
Behavioral Finance and the Psychology of Investing (New York: Oxford University
Press, 2002) and are based on Daniel Kahneman, Paul Slovic, and Amos Tversky,
Judgment under Uncertainty: Heuristics and Biases (New York: Cambridge Univer-
sity Press, 1982).

440 INVESTMENTS
Behavioral Finance Theme 1 involves the concept of heuristics. Heuris-
tics are rules of thumb or guides that individuals will pursue to reduce the
time required to make a decision. For example, in planning for retirement,a rule of thumb that has been suggested for having sufﬁcient funds to retire
is to invest 10% of annual pretax income. As for what to invest into reach

that retirement goal (that is, the allocation among asset classes), a rule ofthumb that has been suggested is that the percentage that an investor should
allocate to bonds should be determined by subtracting that investor’s age
from 100. So, for example, a 45-year old individual should invest 55% ofhis or her retirement funds in bonds.
Although there are circumstances where heuristics can work fairly well,

studies in the ﬁeld of psychology suggest that heuristics can lead to sys-tematic biases in decision making. This systematic bias is referred to by
psychologists as cognitive biases. In the context of ﬁnance, these biases lead
to errors in making investment decisions, or heuristic-driven biases.
14Con-
trast this with the assumption made in the theory of portfolio selection thatall investors estimate the mean and variance of every asset return and based

on those estimates construct an optimal portfolio for each level of risk (i.e.,
the efﬁcient frontier).
EXAMPLES OF COGNITIVE BIASES
■Anchoring. The tendency for an individual to focus either on a past
reference or on a speciﬁc piece of information, without considering
the complete set of information.
■Bandwagon effect. The tendency of individuals to go along with
what others are doing.
■Conﬁrmation bias. The interpretation or seeking of information

that supports oneself or conﬁrms a hypothesis.
■Disposition effect. The tendency of investors to hold on to assets
that have declined in value, yet sell assets that have increased invalue.
■Framing. Making decisions considering the manner or presenta-
tion of the situation.
14Shefrin, Beyond Greed and Fear: Understanding Behavioral Finance and the Psy-
chology of Investing .

The Theory of Portfolio Selection 441
■Gamblers’ fallacy. The belief that probabilities in the future are
affected by past events.
■Negative bias. The tendency for individuals to focus more on the
negative than positive.
■Overconﬁdence bias. The tendency to exaggerate one’s own ability
to judge the value of an asset.
■Self-serving bias. Interpretation of information that puts oneself in

a better light.
Behavioral Finance Theme 2 involves the concept of framing. This term
deals with the way in which a situation or choice is presented to an investor.
Behavioral ﬁnance theorists argue that the framing of investment choices
can result in signiﬁcantly different assessments by an investor as to the risk
and return of each choice and, therefore, the ultimate decision made.15
Behavioral Finance Theme 3 recognizes that not all participants in

markets are rational and that occasional mispricing may occur due to thisirrationality. This irrationality may stem from cognitive biases such as over-
conﬁdence and herding, and may result in a divergence between an asset’sprice, as observed in the market, and an asset’s intrinsic value.
Behavioral theories may explain what we observe that may not be con-
sistent with traditional theories of ﬁnance, but it also helps explain whyinvestors make the choices they do based on risk aversion.

■Combining assets in a portfolio whose returns are not perfectly, posi-tively correlated with one another can reduce the risk of the portfoliothrough diversiﬁcation. Diversiﬁcation allows an entity to reduce risk,
to a point, without necessarily sacriﬁcing return.
■Given the set of all possible combinations of assets that we can form,
there will be some portfolios that are better than others in terms of risk

and return. The efﬁcient frontier is the set of portfolios that have the
highest return for a given level of risk or, equivalently, the lowest riskfor a given return.
15See Amos Tversky and Daniel Kahneman, “The Framing of Decisions and the
Psychology of Choice,” Science 211 (1961): 453–458; and Amos Tversky and Daniel
Kahneman, “Rational Choice and the Framing of Decisions,” Journal of Business
59 (1986): S251–S278.

442 INVESTMENTS
■For a given investor, the portfolio that is best from those on the efﬁcient
frontier depends on the investor’s individual preference for return anddislike for risk.

■Though portfolio theory focuses on the portfolio’s variance and stan-dard deviation as measures of risk, there are alternative measures of riskthat focus on the downside risk, including the mean absolute deviation,
semivariance, and value at risk.
■Behavioral ﬁnance uses the analysis of cognitive biases of individuals to
explain observed market behavior, some of which may not be consistent
with the traditional view of the rational investor.

Correlation and Covariance
Asset Two
1 20% 30% 0.500 0.030
2 20% 50% 0.200 0.020
3 60% 30% −0.500 −0.090
4 25% 25% 0.250 0.016
5 40% 20% 0.800 0.064
Possible
OutcomeProbability
of
OccurrenceReturn
on Asset
ThreeReturn
on Asset
FourReturn on
Asset Three ×

on Asset
Asset Four ×
1 25% 12% 21% 0.0300 0.0525
2 45% 10% 14% 0.0450 0.0630
3 30% 8% 9% 0.0240 0.0270
Total 100% 0.0990 0.1425
Expected return on Asset Three =9.9%
Expected return on Asset Four =14.25%

The Theory of Portfolio Selection 443
Standard Deviation of a Distribution
Asset Five
Possible
Expected ReturnReturn Less Expected
Return SquaredProbability ×
1 0.2000 0.2000 0.2000
2 0.2000 0.2000 0.2000
3 0.2000 0.2000 0.2000
Variance = 0.0080
Standard deviation = 8.93%
Asset Six
Possible

1 0.2000 0.0400 0.0100
2 0.0000 0.0000 0.0000
3 −0.2000 0.0400 0.0100
Variance = 0.0200
Standard deviation = 14.14%
QUESTIONS
1.What is meant by a utility function?
2.If two assets’ returns are positively correlated, what is the covariancebetween the returns of these two assets?
3.What is the relation between the correlation between and among assetsand diversiﬁcation?

4.How does an efﬁcient portfolio relate to a feasible portfolio?
5.What information does the semivariance convey?
6.What is a safety-ﬁrst rule?
7.What is prospect theory?
8.What is meant by framing and how may this affect an investor’s decisionmaking?
9.Identify three safety-ﬁrst methods.
10.What is a cognitive bias and how might it affect investors’ decisionmaking?

444 INVESTMENTS
11.The covariance of returns on Asset A and Asset B are negative.
a.What does this tell us about the correlation coefﬁcient for theirreturns?
b.If we form a portfolio comprised of Asset A and Asset B, what isthe relation between the portfolio’s risk and the risks of Asset A andAsset B considered separately?

12.Consider the following stocks and their expected returns and standarddeviations:
Stock Expected Return Standard Deviation
A 10% 14%
B 10% 13%
C 12% 12%
D 12% 14%
a.Between Stock A and Stock B, which would a risk-averse investorprefer? Explain.
b.Between Stock C and Stock D, which would a risk-averse investorprefer? Explain.
c.Between Stock B and Stock C, which would a risk-averse investor
prefer? Explain.
13.If the economy recovers next year, analysts expect Stock X’s return for

the year to be 20%; if the economy does not recover, analysts expect
Stock X’s return for the year to be −5%. If there is a 40% chance that
the economy will recover and a 60% that it will not, what is:
a.The expected return on Stock X for next year?
b.The standard deviation of the return on Stock X for next year?
14.If the economy recovers next year, analysts expect Stock Y’s return forthe year to be 15%; if the economy does not recover, analysts expect

Stock Y’s return for the year to be −15%. If there is a 50% chance that
the economy will recover, and a 50% that it will not, what is:
a.The expected return on Stock Y for next year?
b.The standard deviation of the return on Stock Y for next year?
15.Consider a portfolio comprised of two securities, M and N. The cor-
relation of the returns on these securities is 0.25. And suppose that

these securities have different standard deviations. Explain how differ-ent combinations of these two securities can result in different estimates
for portfolio risks.

c17 JWBT310-Fabozzi July 1, 2010 20:25 Printer: Courier Westford, Westford, MA
CHAPTER17
Asset Pricing Theory
There are two key messages in CAPM, if you get down to the
bedrock. One is that a broadly diversiﬁed market-like portfolio is
a very good thing to think about. That gave rise to the notion of
the index fund. That is an important message, as strange andheretical as it seemed when we ﬁrst started.
The other message is that to get a higher expected return, you

have got to accept a higher beta value. There is also a broaderversion. What kind of risk do you expect to get rewarded for in the
long term? Answer: the risk of doing badly in bad times. If there is
a reward for bearing risk, it almost has to be that. Otherwise, theworld makes no sense at all. The premium for bearing risk is
related to the risk that just when you need it, you are going to be

poor. If that kind of risk is not rewarded, then there is no reasonto believe that there is a risk premium for stocks as opposed to
putting your money in the bank. In the CAPM world, beta is the
measure of how badly you do in bad times—high beta securities orportfolios are going to really tank if the market goes down.
—William F. Sharpe, “The Gurus,”
CFO Magazine, January 2000

Asset pricing theory seeks to describe the relationship between risk andexpected return. Although we refer to asset pricing models in this chap-
ter, what we mean is the expected return investors require given the riskassociated with an investment. The two most well-known equilibrium assetpricing models are the capital asset pricing model and the arbitrage pricing
theory model. In this chapter, we describe these two models.
445

446 INVESTMENTS
CHARACTERISTICS OF AN ASSET PRICING MODEL
In well-functioning capital markets, an investor should be rewarded for
accepting the various risks associated with investing in an asset. We often
refer to risks as “risk factors” or “factors.” We can express an asset pricing
model in general terms based on risk factors as follows:
E(Ri)=f(F1,F2,F3,...FN) (17.1)

where: E(R i)is the expected return for asset i.
Fk is the risk factor k.
N is the number of risk factors.
In other words, the expected return on an asset is the function of Nrisk
factors. The trick is to determine what the risk factors are and to specify theprecise relationship between expected return and the risk factors.
We can ﬁne-tune the asset pricing model given by equation (17.1) by

thinking about the minimum expected return we would want from investingin an asset. Securities issued by the U.S. Department of the Treasury offer a
known return if held over some period of time. The expected return offeredon such securities is the risk-free return or the risk-free rate because we
believe these securities to have no default risk. By investing in an asset other

than such securities, investors will demand a premium over the risk-free rate.That is, the expected return that an investor will require is:
E(R
i)=Rf+Risk premium
where Rfis the risk-free rate.
The “risk premium,” or additional return expected over the risk-free
rate, depends on the risk factors associated with investing in the asset. Thus,we can rewrite the general form of the asset pricing model given by equation(17.1) as:
E(R
i)=Rf+f(F1,F2,F3,...FN) (17.2)

E(R
We can divide risk factors into two general categories. The ﬁrst category
is risk factors that cannot be reduced with diversiﬁcation. That is, no matterwhat the investor does, the investor cannot eliminate these risk factors. We

Asset Pricing Theory 447
refer to these risk factors as systematic risk factors ornondiversiﬁable risk
factors. The second category is risk factors that can be eliminated through
diversiﬁcation. These risk factors are unique to the asset and are referred to
asunsystematic risk factors ordiversiﬁable risk factors.
SYSTEMATIC RISK VS. SYSTEMIC RISK

The recent ﬁnancial crisis has elevated the use of the word systemic.
Systemic risk should not be confused with systematic risk:
■Systemic risk is risk that is inherent within an entire economy
or organism and generally refers to the risk that the economy or
organism may collapse.
■Systematic risk is the risk that cannot be diversiﬁed away.
THE CAPITAL ASSET PRICING MODEL
The ﬁrst asset pricing model, the capital asset pricing model (CAPM), was de-

rived from economic theory formulated by the individual works of WilliamSharpe, John Lintner, Jack Treynor, and Jan Mossin.
1The CAPM has only
one systematic risk factor—the risk of the overall movement of the market,which we refer to as market risk. So, in the CAPM, market risk and system-

atic risk are interchangeable terms. Market risk means the risk associatedwith holding a portfolio consisting of all assets; that is, the market portfolio.In the market portfolio, an asset is held in proportion to its market value.
For example, if the total market value of all assets is $ Xand the market value
of asset jis $Y, then asset jcomprises $Y ÷$Xof the market portfolio.
1William F. Sharpe, “Capital Asset Prices,” Journal of Finance 19 (1964): 425–442;

John Lintner, “The Valuation of Risk Assets and the Selection of Risky Investments
in Stock Portfolio and Capital Budgets,” Review of Economics and Statistics 47
(1965): 13–37; Jack L. Treynor, “Toward a Theory of Market Value of RiskyAssets,” unpublished manuscript, 1962; and Jan Mossin, “Equilibrium in Capital
Asset Market,” Econometrica 34 (1965): 768–783.

448 INVESTMENTS
In the CAPM, the expected return on asset iis
E(Ri)=Rf+βi[E(RM)−Rf] (17.3)
where: E(RM) is the expected return on the market portfolio.
βi is the measures of systematic risk of asset irelative to the
market portfolio.
What does this tell us about the expected returns? The expected return
for an asset i,according to the CAPM, is equal to the risk-free rate plus a

risk premium. The risk premium is βi[E(R M)−Rf)]. Another way of looking
at this is that the risk premium on the market portfolio is E(RM)−Rf, and
we use βito adjust this for the systematic risk of asset i.
Beta, βi, is a measure of the sensitivity of the return of asset ito the
return of the market portfolio. Therefore,
βi=1.0 The asset or portfolio has the same quantity of risk as the
βi>1.0 The asset or portfolio has more market risk than the

βi<1.0 The asset or portfolio has less market risk than the
The second component of the risk premium in the CAPM is the dif-
ference between the expected return on the market portfolio, E(R M), and
the risk-free rate. It measures the potential reward for taking on the risk of
the market above what can earned by investing in an asset that offers a
risk-free rate.
Taken together, the risk premium is a product of the quantity of market

risk (as measured by beta, βi) and the potential compensation of taking on
market risk, E(RM)−Rf.
Let’s use some values for beta to see if all of this makes sense. Suppose
that a portfolio has a beta of zero. That is, the return for this portfolio has nomarket risk. Substituting zero for β
iin the CAPM given by equation (17.3),
the expected return is equal to the risk-free rate. This makes sense since aportfolio that has no market risk should have an expected return equal tothe risk-free rate.

Consider a portfolio that has a beta of 1. This portfolio has the same
market risk as the market portfolio. Substituting 1 for β
iin the CAPM
given by equation (17.3), the expected return is equal to that of the market
portfolio. Again, this is what one should expect for the return of this port-
folio since it has the same market risk exposure as the market portfolio.

Asset Pricing Theory 449
If a portfolio has greater market risk than the market portfolio, beta
will be greater than 1 and the expected return will be greater than that of
the market portfolio. If a portfolio has less market risk than the market
portfolio, beta will be less than 1 and the expected return will be less than
that of the market portfolio.
Assumptions of the CAPM

The CAPM is an abstraction of real world capital markets and, as such,is based on some assumptions. These assumptions simplify matters a greatdeal, and some of them may even seem unrealistic. However, these assump-
tions make the CAPM more tractable from a mathematical standpoint. The
CAPM assumptions are as follows:
Assumption 1: Investors make investment decisions based on the
expected return and variance of returns and subscribe to the

Markowitz method of portfolio diversiﬁcation.
Assumption 2: Investors are rational and risk averse.
Assumption 3: Investors all invest for the same period of time.
Assumption 4: Investors have the same expectations about the expected
return and variance of all assets.
Assumption 5: There is a risk-free asset and investors can borrow and
lend any amount at the risk-free rate.
Assumption 6: Capital markets are completely competitive and friction-
less.

less.
The ﬁrst four assumptions deal with the way investors make decisions.
The last two assumptions relate to characteristics of the capital market.
These assumptions require further explanation. Many of these assumptions
have been challenged resulting in modiﬁcations of the CAPM. Behavioral
ﬁnance is highly critical of these assumptions, resulting in the formulationof a different CAPM theory that we describe later.
Let’s look at Assumption 1. Recall from the theory of portfolio selection

that Harry Markowitz formulated a framework for constructing a portfo-lio that maximizes expected returns consistent with individually acceptable
levels of risk.
2The measure of risk that Markowitz proposed is the variance
or standard deviation of the return of an asset. In this framework, investors
make decisions based on expected returns and the variance of returns.
2Harry M. Markowitz, “Portfolio Selection,” Journal of Finance 7 (1952): 77–91.

450 INVESTMENTS
The expected return for an asset’s return is typically estimated from the
historical mean of an asset’s return over some time period. Consequently, the
terms “expected return” and “mean return” are often used interchangeably.
For this reason, the theory of portfolio selection is often referred to as mean-

variance portfolio analysis or simply mean-variance analysis. The focus ofportfolio selection is not on the risk of individual securities but the risk of
the portfolio. This theory shows that it is possible to combine risky assets
to produce a portfolio whose expected return reﬂects its components, butwith considerably lower risk. In other words, it is possible to construct a
portfolio whose risk is smaller than the sum of all its individual parts.

Assumption 2 indicates that in order to accept greater risk, investors
must be compensated by the opportunity of realizing a higher return. Werefer to the behavior of such investors as being risk averse. What this means
is that if an investor faces a choice between two portfolios with the sameexpected return, the investor will select the portfolio with the lower risk.
Assumption 3 states that all investors make investment decisions over

some single-period investment horizon. The theory does not specify howlong that period is (i.e., six months, one year, two years, and so on). In
reality, the investment decision process is more complex than that, withmany investors having more than one investment horizon. Nonetheless, the
assumption of a one-period investment horizon is necessary to simplify the
mathematics of the theory.
Assumption 4 states that investors have the same expectations with

respect to the inputs that are used to derive efﬁcient portfolios: asset returns,variances, and correlations/covariances. The assumption allows investors tocompute the efﬁcient frontier, which is the set of portfolios with the best
risk–return combination. We refer to Assumption 4 as the “homogeneous
expectations assumption.”
Assumption 5 is important in deriving the CAPM because it allows for

a risk-free asset, and unlimited borrowing and lending at this risk-free rate.This is because efﬁcient portfolios are created for portfolios consisting of
risky assets. In the CAPM, we assume not only that there is a risk-free asset,
but that an investor can borrow funds at the same interest rate paid ona risk-free asset. This is a common assumption in many economic models
developed in ﬁnance despite the fact it is well understood in reality that there

is a different rate at which investors can borrow and lend funds.
Finally, Assumption 6 speciﬁes that the capital market is perfectly com-
petitive. In general, this means the number of buyers and sellers is sufﬁcientlylarge, and all investors are small enough relative to the market so that noindividual investor can inﬂuence an asset’s price. Consequently, all investors
are price takers, and the market price is determined where there is equality

Asset Pricing Theory 451
Standard DeviationM
PB
RfPAEfficient
frontierCapital
market line
EXHIBIT 17.1 The CAPM and the Efﬁcient Frontier
of supply and demand. In addition, according to this assumption, there are
no transaction costs or impediments that interfere with the supply of anddemand for an asset.
3
In economic modeling, the model is modiﬁed by relaxing one or more

of the assumptions. There are several extensions and modiﬁcations of theCAPM, but we will not review them here. No matter the extension or
modiﬁcation, however, the basic implications are unchanged: investors are
only rewarded for taking on systematic risk and the only systematic risk is
market risk.
The Capital Market Line
To derive the CAPM, we begin with the efﬁcient frontier from the theory

of portfolio selection, which we show in Exhibit 17.1. Every point on theefﬁcient frontier is derived as explained earlier and is the maximum portfolio
return for a given level of risk. In the ﬁgure, risk is measured on the horizontal
axis by the standard deviation of the portfolio’s return, which is the squareroot of the variance.
In the efﬁcient frontier, there is no consideration of a risk-free asset. In
the absence of a risk-free rate, we can construct efﬁcient portfolios based

3Economists refer to these various costs and impediments as “frictions.” The costs
associated with frictions generally result in buyers paying more than in the absence
of frictions and sellers receiving less.

452 INVESTMENTS
on a portfolio’s expected return and variance, with the optimal portfolio
being the one portfolio that is tangent to the investor’s indifference curve.The efﬁcient frontier changes, however, once a risk-free asset is introduced
and we assume that investors can borrow and lend at the risk-free rate
(Assumption 6). We illustrate this in Exhibit 17.1.

Every combination of the risk-free asset and the efﬁcient portfolio de-
noted by point Mis shown on the line drawn from the vertical axis at
the risk-free rate tangent to the efﬁcient frontier. The point of tangency isdenoted by M.All the portfolios on the straight line are feasible for the in-
vestor to construct by combining the market portfolio and either borrowingor lending.
■Portfolios to the left of portfolio Mrepresent combinations of risky
assets and the risk-free asset.

■Portfolios to the right of Minclude purchases of risky assets made with
funds borrowed at the risk-free rate. Such a portfolio is called a leveraged
portfolio because it involves the use of borrowed funds.
The line from the risk-free rate that is tangent to portfolio Mis called
thecapital market line (CML).
Let’s compare a portfolio on the CML to a portfolio on the efﬁcient
frontier with the same risk. For example, compare portfolio PA, which is on

the efﬁcient frontier, with portfolio PB, which is on the CML and, therefore,
is comprised of some combination of the risk-free asset and the efﬁcientportfolio M.Notice that for the same risk, the expected return is greater for
P
Bthan for PA. By Assumption 2, a risk-averse investor will prefer PBtoPA.
That is, PBwill dominate PA. In fact, this is true for all but one portfolio on
the CML: portfolio M, the market portfolio.
Once we introduce the risk-free asset into the mix, we can now say that

an investor will select a portfolio on the CML that represents a combination
of borrowing or lending at the risk-free rate and the efﬁcient portfolio M.The
particular efﬁcient portfolio on the CML that the investor selects depends
on the investor’s risk preference. This can be seen in Exhibit 17.2, which is
similar to Exhibit 17.1, but we have added the investor’s indifference curves.
The investor selects the portfolio on the CML that is tangent to the highestindifference curve, u

2in the exhibit. Notice that without the risk-free asset,
an investor could only get to u1, which is the indifference curve that is
tangent to the efﬁcient frontier. Thus, the opportunity to borrow or lend atthe risk-free rate results in a capital market where risk-averse investors will
prefer to hold portfolios consisting of combinations of the risk-free asset
and some portfolio Mon the efﬁcient frontier.

Asset Pricing Theory 453
Standard DeviationEfficient
PD
PC
RfMu2
u1
EXHIBIT 17.2 The CAPM and Utility Curves
Based on the model assumptions, we can use a bit of algebra to de-
rive the formula for the CML. Based on the assumption of homogeneous
expectations (Assumption 4), all investors can create an efﬁcient portfolio

consisting of wf, placed in the risk-free asset, and wMin portfolio M, where
wrepresents the corresponding percentage weight of the portfolio allocated
to each asset. We will refer to portfolio Mas the risky asset. Therefore,
wf+wM=1
or
wf=1−wM
The expected return is equal to the weighted average of the expected
return of the two assets. Therefore, the expected portfolio return, E(R p), is
E(Rp)=wfRf+wME(RM)
We know that wf=1–w M,s ow ec a nr e w r i t e E(R p)a s
E(Rp)=(1−wM)Rf+wME(RM)

Based on the model assumptions and a bit of algebra,
E(Rp)=Rf+wM[E(RM)−Rf] (17.4)

454 INVESTMENTS
where wrepresents the percentage (weight) of the portfolio allocated to an
asset with the subscript fandMdenoting the percentage allocated to the
risk-free asset and risky asset, respectively. Note that the sum of the two
weights must equal 1.
Now let’s determine the formula for the variance for a two-asset port-

folio, with the risk-free asset and one risky asset Mas the two assets:
σ2(Rp)=w2
iσ2(Rf)+w2
jσ2(RM)+2wfwMcov(RfRM)
The variance of the risk-free asset is zero (i.e., σ2(Rf)=0), and the
covariance between the risky asset and the risk-free asset is also zero (i.e.,cov(R
fRM)=0). The variance of the risk-free asset is zero because there
is no possible variation in the return since the future return is known. The
covariance between the risk-free asset and the risky asset is zero because the

risk-free asset has no variability.
The variance of the portfolio consisting of the risk-free asset and risky
asset is then:
σ2(
Rp)
=w2
jσ2(RM)
In other words, the variance of the portfolio is represented by the weighted
variance of the risky asset M.
We can solve for the weight of the risky asset Mby substituting standard
deviations for variances. Because the standard deviation of the portfolio(σ(R
p)) is the square root of the variance, we can write the standard deviation

of the portfolio consisting of the risk-free asset and the risky asset Mas
σ(Rp)=wMσ(RM)
wM=σ(Rp)
σ(RM)
If we substitute the above result for wMin equation (17.4) and rearrange
terms we get the CML:
E(Rp)=Rf+[E(RM)−Rf
σ(RM)]
σ(
Rp)
(17.5)

Asset Pricing Theory 455
What Is Portfolio M?
Now that we know that risky asset Mis pivotal to the CML, what is risky
asset M? That is, how does an investor select risky asset M? It has been
proven by ﬁnancial theorists that risky asset Mis not a single asset but
rather a portfolio consisting of all assets available to investors, with each

asset held in proportion to its market value relative to the total market value
of all assets.4That is, portfolio Mis the market portfolio described earlier.
So, rather than referring to risky asset Mas the market portfolio, we often
simply refer to this portfolio as the market.
The Risk Premium in the Capital Market Line
With homogeneous expectations, σ(RM) and σ(Rp) are the market’s con-
sensus for the expected return distributions for portfolio Mand portfolio p.

The risk premium for the CML is
E(RM−Rf)
σ(RM)σ(Rp)
Let’s examine the economic meaning of the risk premium. The numer-
ator of the ﬁrst term, E(RM)−Rf, is the expected return from investing in
the market beyond the risk-free return. It is a measure of the reward for
holding the risky market portfolio rather than the risk-free asset. The de-
nominator, σ(RM), is the market risk of the market portfolio. Thus, the ﬁrst
term, E(
RM−Rf)/
σ(RM), is the measure the reward per unit of market

risk. Because the CML represents the return offered to compensate for a per-ceived level of risk, each point on the CML is a balanced market condition,
or equilibrium. The slope of the CML (that is, the ﬁrst term) determinesthe additional return needed to compensate for a unit change in risk. That
is why we refer to the slope of the CML as the equilibrium market price
of risk.
Therefore, along the CML, the expected return on a portfolio is equal

to the risk-free rate, plus a risk premium equal to the market price of risk(as measured by the reward per unit of market risk), multiplied by the
quantity of risk for the portfolio (as measured by the standard deviation of
the portfolio). That is,
E(R
p)=Rf+(Market price of risk ×Quantity of risk)
Work,” Journal of Finance 25 (1970): 383–417.

456 INVESTMENTS
Systematic and Unsystematic Risk
Now we know that a risk-averse investor who makes decisions based on
expected return and variance should construct an efﬁcient portfolio using a
combination of the market portfolio and the risk-free rate. The combinations
are identiﬁed by the CML.
We can ﬁne-tune our thinking about the risk associated with an asset,

using the pricing model developed by William Sharpe.5Speciﬁcally, we can
show that the appropriate risk that investors should be compensated foraccepting is not the variance of an asset’s return but some other quantity. In
order to do this, let’s take a closer look at risk.
We can do this by looking at the variance of the portfolio. The variance
of the market portfolio containing Nassets is equal to
σ
2(RM)=w1,Mcov(R1,RM)+w2,Mcov(R2,RM)
+w 3,Mcov(R3,RM)+···+ wN,Mcov(RN,RM)(17.6)

where wi,Mis equal to the proportion invested in asset iin the market
portfolio. Notice that the portfolio variance does not depend on the variance
of the assets comprising the market portfolio, but rather their covariancewith the market portfolio.
Sharpe deﬁnes the degree to which an asset covaries with the market

portfolio as the asset’s systematic risk. More speciﬁcally, he deﬁnes system-atic risk as the portion of an asset’s variability that can be attributed to a
common factor. Systematic risk is the minimum level of risk that can be
obtained for a portfolio by means of diversiﬁcation across a large number ofrandomly chosen assets. As such, systematic risk is that which results from
general market and economic conditions that cannot be diversiﬁed away.

Sharpe deﬁnes the portion of an asset’s variability that can be diversiﬁed
away as nonsystematic risk. This is the risk that is unique to an asset.
SYSTEMATIC AND UNSYSTEMATIC RISK
Systematic Risk Is
also Known as:Unsystematic Risk Isalso Known as:
Market risk Diversiﬁable risk
Undiversiﬁable risk Unique risk
Nondiversiﬁable risk Residual risk
Company-speciﬁc risk
5Sharpe, “Capital Asset Prices.”

Asset Pricing Theory 457
Portfolio Risk
Number of Holdings in the PortfolioTotal risk Systematic riskUnsystematic risk
EXHIBIT 17.3 Components of Portfolio Risk
Consequently, total risk (as measured by the variance) can be partitioned
into systematic risk as measured by the covariance of asset i’s return with
the market portfolio’s return and nonsystematic risk. The relevant risk for

decision-making purposes is the systematic risk.
We illustrate how diversiﬁcation reduces nonsystematic risk for portfo-
lios in Exhibit 17.3. The vertical axis shows the variance of the portfolioreturn. The variance of the portfolio return represents the total risk for theportfolio (that is, systematic plus nonsystematic). The horizontal axis shows
the number of holdings of different assets (e.g., the number of common stock

held of different issuers). As you can see, as the number of asset holdings in-creases, the level of nonsystematic risk is almost completely eliminated (that
is, diversiﬁed away). Studies of different asset classes support this. For exam-
ple, for common stock, several studies suggest that a portfolio size of about20 randomly-selected companies will completely eliminate nonsystematic
risk leaving only systematic risk.
6
The Security Market Line

6
The CML represents an equilibrium condition in which the expected return
on a portfolio of assets is a linear function of the expected return of the
market portfolio. Individual assets do not fall on the CML. For individual
assets, we expect the following to hold:
E(Ri)=Rf+E(RM)−Rf
σ2(RM)cov(Ri,RM) (17.7)
This is the security market line (SML).
6Wayne H. Wagner and Shiela C. Lau, “The Effect of Diversiﬁcation on Risks,”
Financial Analysts Journal 27 (1971): 48–53.

458 INVESTMENTS
In equilibrium, the expected return of individual assets lies on the SML,
but not on the CML. This is because of the high degree of nonsystematic risk
that remains in individual assets that can be diversiﬁed out of portfolios. In
equilibrium, only efﬁcient portfolios lie on both the CML and the SML.
We can also express the SML as
E(Ri)=Rf+(
E(RM)−Rf)[cov(Ri,RM)
σ2(RM)]

σ2(RM)]
(17.8)
How can we estimate the ratio in equation (17.8) for each asset? We can
do so empirically using return data for the market portfolio and the return
on the asset. The empirical analogue for equation (17.8) is
rit−Rf=αi+βi(rMt−rft)+εit (17.9)
where εitis the error term, and βiis the estimate of cov( Ri,RM)/σ2(RM).
Equation (17.8) is the characteristic line.
Substituting βiinto the SML given by equation (17.8) gives the beta
version of the SML:

E(Ri)=Rf+βi(E(RM)−Rf) (17.10)
This is the CAPM form given by equation (17.3). This equation states
that, given the assumptions of the CAPM, the expected return on an indi-vidual asset is a positive, linear function of its index of systematic risk asmeasured by beta. The higher the beta, the higher the expected return.
EXAMPLE 17.1
Suppose the risk-free asset’s rate of return is 2% and you forecast a
return on the market portfolio of 8%. If the beta for some asset xis

1.2, what is the expected return on asset x?
Solution
E(Ri)=Rf+βi(E(RM)−Rf)
E(Ri)=0.02+1.2(0.08−0.02) =9.2%

Asset Pricing Theory 459
An investor pursuing an active portfolio strategy searches for under-
priced assets to purchase or retain and overpriced assets to sell or avoid
(if held in the current portfolio, or sold short if permitted). If an investor
believes that the CAPM is the correct asset pricing model, the investor can
use the SML to identify mispriced securities.

■An asset is perceived to be underpriced (that is, undervalued) if the
“expected” return projected by the investor is greater than the return
stipulated by the SML.
■An asset is perceived to be overpriced (that is, overvalued), if the ex-
pected return projected by the investor is less than the return stipulated
by the SML.

by the SML.
Said another way, if the expected return of an asset plots above the SML,the asset is underpriced; if it plots below the SML, it is overpriced.
TRY IT! EXPECTED RETURNS
AssetReturn on
the Risk-Free
AssetExpected
Return on
the Market BetaExpected
Return on
the Asset
1 1.0% 10.0% 10.00%
22 . 0 % 0.8 10.80%
3 8.0% 1.3 9.65%
4 3.0% 9.0% 0.9
Tests of the CAPM

Now, that’s the theory. The question is whether or not the theory is sup-ported by empirical evidence. There has been a large number of academicpapers written on the subject, with researchers in almost all studies using
common stock to test the theory. These papers cover not only the empirical
evidence, but the challenges to testing the theory.
Let’s start with the empirical evidence. There are two important results

of the empirical tests of the CAPM that question its validity. First, it hasbeen found that stocks with low betas have exhibited higher returns than the

460 INVESTMENTS
CAPM predicts and stocks with high betas have been found to have lower
returns than the CAPM predicts. Second, market risk is not the only riskfactor priced by the market. Several studies have discovered other factors
that explain stock returns.
While on the empirical level there are serious questions raised about

the CAPM, there is an important paper challenging the validity of theseempirical studies. Richard Roll demonstrates that the CAPM is not testable
until the exact composition of the “true” market portfolio is known, andthe only valid test of the CAPM is to observe whether the ex ante true
market portfolio is mean-variance efﬁcient.
7As a result of his work, Roll
argues that there will never be an unambiguous test of the CAPM. He does

not say that the CAPM is invalid. Rather, Roll says that there is likely to
be no unambiguous way to test the CAPM and its implications due to the
fact that we cannot observe the true, theoretical market portfolio and its
characteristics.
Criticisms of the CAPM
There have been attacks on the CAPM from those who believe that this cor-
nerstone theory of ﬁnance is on shaky grounds. The three major attacks are
Attack 1: The use of the standard deviation or variance as a measure of

risk does not capture what is observed in ﬁnancial markets regardingthe probability distribution of asset returns.
Attack 2: The behavioral assumptions of the CAPM do not reﬂect the
way investors make portfolio decisions in the real world.
Attack 3: There is evidence that there is more than one risk factor that
affects asset returns.
Attack 1 is essentially a criticism of an assumption that the return dis-

tribution for asset returns follows a normal distribution. Attack 2 is thecriticism of proponents of behavioral ﬁnance theory who, as explained inthe previous chapter, have attacked economic theories based on observing
how economic agents such as investors actually go about making decisions.
Finally, an alternative economic theory of asset pricing, such as the arbi-trage pricing model, is based on more than one factor. One such model is
the subject of the next section.

7Richard R. Roll, “A Critique of the Asset Pricing Theory’s Tests,” Journal of
Financial Economic 4 (1977): 129–176.

Asset Pricing Theory 461
THE ARBITRAGE PRICING THEORY MODEL
Stephen Ross developed an alternative to the equilibrium asset-pricing model
just discussed, an asset-pricing model based purely on arbitrage arguments.8
The model, called the arbitrage pricing theory (APT) model , postulates that

an asset’s expected return is inﬂuenced by a variety of risk factors, as opposedto just market risk as suggested by the CAPM. According to the APT model,
the return on an asset is linearly related to a number of risk factors. However,
the APT model does not specify what these risk factors are, but in themodel the relationship between asset returns and the risk factors is linear.
Moreover, in the APT model, unsystematic risk can be eliminated so that an

investor is only compensated for accepting the systematic risk factors.
The Arbitrage Principle
The APT relies on arbitrage arguments, but what is arbitrage? In its simpleform, arbitrage is the simultaneous buying and selling of an asset at two
different prices in two different markets. The arbitrageur proﬁts without
risk by buying cheaply in one market and simultaneously selling at thehigher price in the other market. However, such opportunities are rare in

ﬁnancial markets. In fact, a single arbitrageur with unlimited ability to sell
short could correct a mispricing condition by ﬁnancing purchases in the
underpriced market with proceeds of short sales in the overpriced market.
9
This means that any arbitrage opportunities are short-lived.
Less obvious arbitrage opportunities exist in situations where a package
of assets can produce a payoff (that is, expected return) identical to an asset

that is priced differently. This arbitrage relies on a fundamental principle ofﬁnance, the law of one price, which states that a given asset must have the
same price regardless of the means by which one goes about creating thatasset. The law of one price implies that if an investor can synthetically createthe payoff of an asset using a package of assets, the price of the package
and the price of the asset whose payoff it replicates must be equal. When

a situation is discovered whereby the price of the package of assets differsfrom that of an asset with the same payoff, rational investors will trade these
assets in such a way as to restore price equilibrium.
The APT assumes that this arbitrage mechanism is possible, and is
founded on the fact that an arbitrage transaction does not expose the
8Stephen A. Ross, “The Arbitrage Theory of Capital Asset Pricing,” Journal of
Economic Theory 13 (1976): 343–362.

9Short selling means selling an asset that is not owned in anticipation of a price
decline.

462 INVESTMENTS
investor to any adverse movement in the market price of the assets in the
transaction. For example, let us consider how we can produce an arbitrageopportunity involving the three assets A, B, and C. These assets can be pur-
chased today at the prices shown, and can each produce only one of two
payoffs (referred to as State 1 and State 2) a year from now:

Asset Price Payoff in State 1 Payoff in State 2
A $70 $50 $100
B 60 30 120
C 80 38 112
While it is not obvious from the data presented her, an investor can
construct a portfolio consisting of assets A and B that will have the identical
return as asset C in both State 1 and State 2. Let wAandwBbe the proportion
of assets A and B, respectively, in the portfolio. We can specify the payoff
(that is, the terminal value of the portfolio) under the two states as:

If State 1 occurs: Payoff =$50w A+$30w B
If State 2 occurs: Payoff =$100w A+$120w B
Can we create a portfolio consisting of assets A and B that will reproduce
the payoff of C regardless of the state that occurs one year from now? Yes.
Here is how: For either condition (State 1 and State 2), we set the expected
payoff of the portfolio equal to the expected payoff for C, as follows:
State 1: Payoff =$50w A+$30w B=$38
State 2: Payoff =$100w A+$120w B=$112

Because the proportions invested in the two assets must sum to one, we also
know that wA+wB=1.
If we solve for the weights for wAandwBthat would simultaneously
satisfy the preceding equations, we would ﬁnd that the portfolio should have40% in asset A (that is, w
A=0.4) and 60% in asset B (that is, wB=0.6).
The cost of that portfolio will be equal to:
Cost of the portfolio with wA
of 0.4 and wBof 0.6=(0.4×$70)+(0.6×$60)=$64

Our portfolio (that is, package of assets) comprised of assets A and B
has the same payoff in State 1 and State 2 as the payoff of asset C. The costof asset C is $80, whereas the cost of the portfolio is only $64. This is an

Asset Pricing Theory 463
arbitrage opportunity that can be exploited by buying assets A and B in the
proportions given and shorting (selling) asset C.
For example, suppose that we invest $1 million to create the portfolio

with assets A and B. The $1 million is obtained by selling short asset C. Theproceeds from the short sale of asset C provide the funds to purchase assetsA and B. Thus, there would be no cash outlay by the investor. The payoffs
for States 1 and 2 are:
Payoff in
Asset Investment State 1 State 2
A $ 400,000 $ 285,715 $ 571,429
B 600,000 300,000 1,200,000
C −1,000,000 −475,000 −1,400,000
Total $ 0 $ 110,715 $ 371,429
In either State 1 or 2, the investor proﬁts without risk. The APT model

assumes that such an opportunity would be quickly eliminated by the mar-
ketplace.
APT Model Formulation
The APT model postulates that an asset’s expected return is inﬂuenced by
a variety of risk factors, as opposed to just market risk in the case of the
CAPM. That is, the APT model asserts that the return on an asset is linearly
related to H“factors.” The APT does not specify what these factors are, but
it is assumed that the relationship between asset returns and the factors is

linear. Speciﬁcally, the APT model asserts that the rate of return on asset i
is given by the following relationship:
Ri=E(Ri)+βi,1F1+βi,2F2+···+ βi,HFH+ei
where: Ri=the rate of return on asset i
E(R i)=the expected return on asset i
Fh=thehth factor that is common to the returns of all assets
(h=1,...,H)
βi,h=the sensitivity of the ith asset to the hth factor
ei=the unsystematic return for asset i
For equilibrium to exist, the following conditions must be satisﬁed:

Using no additional funds (wealth) and without increasing risk, it should notbe possible, on average, to create a portfolio to increase return. In essence,

464 INVESTMENTS
this condition states that there is no so-called money machine available in
the market.
Ross derived the following relationship, which is what is referred to as
the APT model:
E(Ri)=Rf+βi,F1[E(RF1)−Rf]+βi,F2[E(RF2)−Rf]+···
+βi,FH[E(RFH)−Rf]
where [E(R Fj)−Rf] is the excess return of the jth systematic risk factor

over the risk-free rate, and can be thought of as the price (or risk premium)for the jth systematic risk factor. The derivation of the APT model is much
more mathematically complicated than deriving the CAPM, so we will notprovide the details here.
The APT model asserts that investors want to be compensated for all
the risk factors that systematically affect the return of an asset. The compen-sation is the sum of the products of each risk factor’s systematic risk (β
i,Fh),

i,Fh),
and the risk premium assigned to it by the ﬁnancial market [E(R Fh)−Rf].
As in the case of the CAPM, an investor is not compensated for acceptingunsystematic risk. However, the CAPM states that systematic risk is marketrisk, while the APT model does not specify the systematic risks.
Supporters of the APT model argue that it has several major advantages

over the CAPM. First, it makes less restrictive assumptions about investorpreferences toward risk and return. As explained earlier, the CAPM theory
assumes investors trade off between risk and return solely on the basis of the
expected returns and standard deviations of prospective investments. TheAPT model, in contrast, simply requires some rather unobtrusive bounds
be placed on potential investor utility functions. Second, no assumptions

are made about the distribution of asset returns. Finally, because the APTmodel does not rely on the identiﬁcation of the true market portfolio, the
theory is potentially testable.
Multifactor Risk Models in Practice
The APT model provides theoretical support for an asset pricing modelwhere there is more than one risk factor. Consequently, we refer to these
models as multifactor risk models. These models provide the tools for quan-

tifying the risk proﬁle of a portfolio relative to a benchmark, for constructing
a portfolio relative to a benchmark, and for controlling risk. There are two
types of multifactor risk models used in both equity and bond portfoliomanagement: statistical factor models and fundamental factor models.
In astatistical factor model , historical and cross-sectional data on stock
returns are tossed into a statistical model. The goal of the statistical model is

Asset Pricing Theory 465
to best explain the observed stock returns with factors that are linear return
combinations and uncorrelated with each other. For example, suppose thatyou compute the monthly returns for 5,000 companies for 10 years. The goal
of the statistical analysis is to produce factors that best explain the variance

of the observed stock returns. For example, suppose that there are six factorsthat do this. These factors are statistical artifacts. The objective in a statistical
factor model then becomes to determine the economic meaning of each of
these statistically derived factors. Because of the problem of interpretation,it is difﬁcult to use the factors from a statistical factor model for valuation,
portfolio construction, and risk control. Instead, practitioners prefer the next

model described, which allows an asset manager to prespecify meaningfulfactors and thus produce a more intuitive model.
Fundamental factor models use company and industry attributes and
market data as raw descriptors. Examples of raw descriptors in equity fac-
tor models are price/earnings ratios, book/price ratios, estimated economic
growth, and stock trading activity. The inputs into a fundamental factormodel are stock returns and the raw descriptors about a company. Those

fundamental variables about a company that are pervasive in explaining
stock returns are then the raw descriptors retained in the model. Using cross-sectional analysis, the sensitivity of a stock’s return to a raw descriptor can
be estimated.
SOME PRINCIPLES TO TAKE AWAY
In this chapter we have covered the two principal models associated with
asset pricing theory. We have emphasized the assumptions and their crit-
ical role in the development of these theories. While you may understand

the topics covered, you may still be uncomfortable about where we haveprogressed in ﬁnancial theory, given the lack of theoretical and empirical
support for the CAPM or the difﬁculty of identifying the factors in the APT
model. You’re not alone. A good number of practitioners and academicsfeel uncomfortable with these models, particularly the CAPM.
Nevertheless, what is comforting is that there are several general prin-

ciples of investing that are derived from these theories that very few wouldquestion. They are:
■Investing has two dimensions, risk and return. Therefore, focusing onlyon the actual return without looking at the risk that has to be acceptedto achieve that return is inappropriate.
■It is also inappropriate to look at the risk of an individual asset whendeciding whether it should be included in a portfolio. What is important

466 INVESTMENTS
is how the inclusion of an asset into a portfolio will affect the risk of
■Whether investors consider one risk or a thousand risks, risk can be di-
vided into two general categories: systematic risks that cannot be elim-
inated by diversiﬁcation, and unsystematic risks that can be diversiﬁedaway.

■Investors should be compensated only for accepting systematic risks.Thus, it is critical in formulating an investment strategy to identify thesystematic risks.
■Asset pricing involves determining the expected return investors require
in order to invest in risky assets. The two most well-known equilibrium
pricing models are the capital asset pricing model developed in the 1960sand the arbitrage pricing theory model developed in the mid-1970s.

■The risks associated with assets and portfolios can be divided into sys-tematic risk and unsystematic risk. The latter risks can be eliminated bydiversiﬁcation; the former risks cannot be eliminated by diversifying.
■In deriving the CAPM, assumptions are made. A key assumption is thatinvestors make investment decisions in accordance with the theory ofportfolio selection as formulated by Markowitz. The goal of portfolio
selection is the construction of portfolios that maximize expected returns

consistent with individually acceptable levels of risk.
■In the theory of portfolio selection, risk is measured by the variance (or
standard deviation) and evaluated considering the expected return, and
hence this is often referred to as mean-variance analysis. The CAPMformalizes the relationship that should exist between asset returns and
risk if investors behave in a hypothesized manner. Together, the theory
of portfolio selection and CAPM provide a framework to specify and

measure investment risk, and to develop relationships between expected
asset return and risk (and hence between risk and required return on aninvestment).
■The CAPM asserts that the only risk that is priced by rational investors issystematic risk, because that risk cannot be eliminated by diversiﬁcation.Essentially, the CAPM says that the expected return of an asset or a
portfolio is equal to the rate on a risk-free security asset plus a risk

premium. The risk premium in the CAPM is the product of the quantityof risk as measured by beta multiplied by the market price of risk. An
asset or portfolio’s beta is an index of the systematic risk of the asset.

Asset Pricing Theory 467
■There have been numerous empirical tests of the CAPM, and, in general,
these have failed to fully support the theory. However, these studies havebeen criticized because of the difﬁculty of identifying the true market
portfolio. Further, such tests are not likely to appear soon, if at all,
according to ﬁnancial theorists.

■The arbitrage pricing theory model is developed purely from arbitrage
arguments. The theory postulates that the expected return on an asset
or a portfolio is inﬂuenced by several risk factors. Proponents of theAPT model cite its less restrictive assumptions as a feature that makes it
more appealing than the CAPM. Moreover, testing the APT model does
not require identiﬁcation of the true market portfolio.

■Despite the fact that the two major asset pricing theories—CAPM and
APT—are controversial or may be difﬁcult to implement in practice,
there are several principles of investing that are not controversial that
can be taken away from these theories and applied in formulating port-
folio management strategies.
Expected Returns
AssetReturn on the
Risk-Free
Return on
Return on
the Asset
1 1.0% 10.0% 1.0 10.00%

Return on
the Asset
22 .0% 13.0% 0.8 10.80%
3 2.5% 8.0% 1.3 9.65%
4 3.0% 9.0% 0.9 8.40%
QUESTIONS
1.What is diversiﬁable risk?
2.What is the role of diversiﬁcation in the capital asset pricing model?
3.If investors are risk averse, which would they prefer: a stock with an
expected return of 5% with a beta of 1.2 or a stock with an expected
return of 6% with a beta of 1.3? Explain.
4.If a stock has both diversiﬁable risk and nondiversiﬁable risk, which,

if any, of these risks are considered in the pricing of the asset?

468 INVESTMENTS
5.In the context of the CAPM, what is the term represented by
E(R M)−Rf?
6.Explain what beta represents in terms of asset pricing.
7.If asset A’s beta is greater than asset B’s beta, does this mean that assetA has more risk than asset B? Explain.
8.What is the difference between the security market line and the capital
market line?

9.If a stock’s return and risk are such that this would plot above the
security market line, is this stock overpriced or underpriced?
10.Suppose you expected the return on the market to be 10% and thereturn on the risk-free asset to be 2%. If you are considering a stockwith a beta of 1.2, what is the expected return on this stock according
to the security market line?
11.How should an investor construct an efﬁcient portfolio in the presenceof a risk-free asset?

12.What is the theoretical problem inherent in verifying the CAPM empir-
ically?
13.Why is the CAPM’s assumption that investors can borrow and lend atthe risk-free rate questionable?
14.What is meant by the “homogeneous assumption” in the CAPM?
15.What is meant by the law of one price, and what does it imply about apackage of securities and a given security that have the same payoff?
16.What are the fundamental principles underlying the APT model?

17.What are the advantages of the APT model relative to the CAPM?
18.What are the difﬁculties of applying the arbitrage pricing theory modelin practice?
19.Indicate why you agree or disagree with the following statements:a.“As a percentage of the total risk, the unsystematic risk of a diversi-ﬁed portfolio is greater than that of an individual asset.”
b.“An investor should be compensated for accepting unsystematicrisk.”

20.“In the CAPM, investors should be compensated for accepting sys-tematic risk; for the APT model, investors are rewarded for acceptingboth systematic risk and unsystematic risk.” Do you agree with this
statement?

c18 JWBT310-Fabozzi July 8, 2010 13:19 Printer: Courier Westford, Westford, MA
CHAPTER18
The Structure of
Interest Rates
Some discussion of the arithmetic of longer-term yields provides a
useful perspective on recent developments in bond markets. Theten-year Treasury yield, for example, can be viewed as a weighted
average of the current one-year rate and nine one-year forward

rates, with the weights depending on the coupon yield of thesecurity. [E]ach of these forward rates can be split further into
(1) a portion equal to the one-year spot rate that market
participants currently expect to prevail at the corresponding date inthe future, and (2) a portion that reﬂects additional compensation
to the bondholder for the risk of holding longer-dated instruments.
Current and near-term forward rates are particularly sensitive to

monetary policy actions, which directly affect spot short-terminterest rates and strongly inﬂuence market expectations of where
spot rates are likely to stand in the next year or two.
—Ben S., Bernanke, Chairman of the Federal Reserve,
Speech before the Economic Club of New York,
New York, March 20, 2006
Acasual examination of the ﬁnancial pages of a journal would be enoughto convey the idea that nobody talks about an “interest rate.” There

are interest rates reported for borrowing money and investing. These ratesare not randomly determined; that is, there are factors that systematicallydetermine how interest rates on different types of loans and debt instruments
vary from each other. We refer to this as the structure of interest rates and
we discuss the factors that affect this structure in this chapter.
469

470 INVESTMENTS
THE BASE INTEREST RATE
The securities issued by the U.S. Department of the Treasury, popularly
referred to as Treasury securities or simply Treasuries, are backed by the
full faith and credit of the U.S. government. At the time of this writing,

market participants throughout the world view U.S. Treasuries as beingfree of default risk, although there is the possibility that unwise economic
policy by the U.S. government may alter that perception. While historically
Treasury securities have served as the benchmark interest rates throughoutthe U.S. economy as well as in international capital markets, there are other
important interest rate benchmarks used by market participants that we will
discuss later.

Thebase interest rate is the sum of the real interest rate and the rate of in-
ﬂation. This is the interest rate appropriate for an investment with no defaultrisk. A factor that is important in determining the level of interest rates is the
expected rate of inﬂation. That is, we can express the base interest rate as:
Base interest rate =Real interest rate +Expected rate of inﬂation
The real interest rate is the rate that would exist in the economy in the
absence of inﬂation.

The Risk Premium
Debt instruments not issued or backed by the full faith and credit of theU.S. government are available in the market at an interest rate or yield that
is different from an otherwise comparable maturity Treasury security. We
refer to the difference between the interest rate offered on a non-Treasury
security and a comparable maturity Treasury security as the spread .F o r
example, if the yield on a ﬁve-year non-Treasury security is 5.4% and the

yield on a 10-year Treasury security is 4%, the spread is said to be 1.4%.
Rather than referring to the spread in percentage terms, such as 1.4%,market participants refer to the spread in terms of basis points. A basis
point is equal to 0.01%. Consequently, 1% is equal to 100 basis points. In
our example, the spread of 1.4% is equal to 140 basis points.
The spread exists because of the additional risk or risks to which an

investor is exposed by investing in a security that is not issued by the U.S.government. Consequently, the spread is referred to as a risk premium . Thus,
we can express the interest rate offered on a non-Treasury security with the
same maturity as a Treasury security as:
Interest rate =Base interest rate +Spread

The Structure of Interest Rates 471
or, equivalently,
Interest rate =Base interest rate +Risk premium
While the spread or risk premium is typically positive, there are factors
that can cause the risk premium to be negative. The general factors that
affect the risk premium between a non-Treasury security and a Treasury
security with the same maturity are:

■The market’s perception of the credit risk of the non-Treasury security.
■Any features provided of the non-Treasury security that make it attrac-tive or unattractive to investors.
■The tax treatment of the interest income from the non-Treasury security.
■The expected liquidity of the non-Treasury issue.
Risk Premium Due to Default Risk
Default risk refers to the risk that the issuer of a debt obligation may be

unable to make timely payment of interest or the principal amount when it isdue. Most market participants gauge default risk in terms of the credit rating
assigned by the three major commercial rating companies: (1) Moody’s
Investors Service, (2) Standard & Poor’s Corporation, and (3) Fitch Ratings.These companies, referred to as rating agencies , perform credit analyses of
issuers and issues and express their conclusions by a system of ratings.

We summarize the rating systems used by the three major services in
Exhibit 18.1. These are the major rating classes, though the rating services
S&P and
Fitch Moody’s
AAA Aaa
AA AaHigh
quality
AA
BBB BaaInvestment
grade
BB Ba
BBCCNon-
grade
EXHIBIT 18.1 Credit Ratings

472 INVESTMENTS
breakdown some of these classes to provide more information. For exam-
ple, Moody’s uses 1, 2, or 3 to provide a narrower credit quality break-down within each class; S&P and Fitch use plus and minus signs for the
same purpose.
In all rating systems the term high grade means low credit risk or,

conversely, high probability of future payments. Bonds rated AAA (or Aaa)through BBB (or Baa) are considered investment grade bonds. Issues that
carry a rating below the top four categories are referred to as noninvestment-
grade bonds, or more popularly as high-yield bonds orjunk bonds .
The spread or risk premium between Treasury securities and non-
Treasury securities, which are identical in all respects except for credit rating,

is the credit spread . For example, on August 5, 2008, ﬁnance.yahoo.com re-
ported (based on information supplied by ValuBond) that the ﬁve-year Trea-sury yield was 3.29%. The yield and credit spreads on ﬁve-year corporate
bonds rated AAA, AA, and A were:
RatingYield August 5,
2008Credit Spread
in Basis Points
AAA rated 5.01% 172
AA rated 5.50% 221
A rated 5.78% 249
Note that the lower the credit rating, the higher the credit spread.
TRY IT! CREDIT SPREADS

Complete the following table when the yield on a similar-maturity
Treasury bond is 3.73%:
Rated Bond Yield Credit Spread
AAA rated 4.92%
AA rated 5.43%
A rated 5.90%
BBB rated 6.32%

The Structure of Interest Rates 473
Inclusion of Attractive and Unattractive Provisions
The terms of the loan agreement may contain provisions that make the debt
instrument more or less attractive compared to other debt instruments that
do not have such provisions. When there is a provision attractive to an

investor, the spread decreases relative to a Treasury security of the samematurity. The opposite occurs when there is an unattractive provision: The
spread increases relative to a comparable-maturity Treasury security.
The three most common features found in bond issues are the:
1.Call provision,
2.Put provision, and
3.Conversion provision.
A bond may have one of more of these features—or none of these features.
Acall provision grants the issuer the right to retire the bond issue

prior to the scheduled maturity date. A bond issue that contains such aprovision is a callable bond . The inclusion of a call provision beneﬁts the
issuer by allowing it to replace that bond issue with a lower interest cost bond
issue should interest rates in the market decline. Effectively, a call provision
allows the issuer to alter the maturity of the bond issue. A call provision is

an unattractive feature for the investor (i.e., the bondholder) because thebondholder will not only be uncertain about maturity, but faces the risk that
the issuer will exercise the call provision when interest rates have declined
below the interest rate on the bond issue. As a result, the bondholder mustreinvest the proceeds received when the bond issue is called into another
bond issue paying a lower interest rate. This risk associated with a callable

bond is reinvestment risk . For this reason, investors require compensation
for accepting reinvestment risk and they receive this compensation in the
form of a higher spread or risk premium.
A bond issue with a put provision grants the bondholder the right to
sell the issue back to the issuer at par value on designated dates. A bond
that contains this provision is a putable bond. Unlike a call provision, a put
provision is an advantage to the bondholder. The reason is that if interest

rates rise after the issuance of the bond, the price of the bond will decline.
The put provision allows that bondholder to sell the bond back to the issuer,avoiding a market value loss on the bond and allowing the bondholder to
reinvest the proceeds from the sale of the bond at a higher interest rate.
Hence, a bond issue that contains a put provision will sell in the market ata lower spread than an otherwise comparable-maturity Treasury security.

Aconversion provision grants the bondholder the right to exchange
the bond issue for a speciﬁed number of shares of common stock. A bond

474 INVESTMENTS
with this provision is a convertible bond . The conversion provision allows
the bondholder the opportunity to beneﬁt from a favorable movement in
the price of the stock into which it can exchange the bond. Hence, theconversion provision results in a lower spread relative to a comparable-
maturity Treasury issue. For example, the provision may specify that the

bond may be exchanged into 50 shares of the common stock of the issue.The investor then compares the value of the bond as a bond with the value
converted into the common stock.
The three provisions we have described are, effectively, options. Unlike
a traded option, such as a stock option, these provisions are referred to asembedded options because they are options embedded in a bond issue.
EXAMPLE 18.1: CALLABLE DEBT
Kellogg Co. issued $1.1 of callable debentures in 2001 that mature

April 1, 2031. The debentures are callable by Kellogg at par value.Therefore, Kellogg has a call option on these debentures: it can buy
these debentures back from the investors at 100% of the principal
amount, plus accrued interest.
Taxability of Interest
The U.S. federal tax code speciﬁes that interest income is taxable at the
federal income tax level unless otherwise exempted. The federal tax code

speciﬁcally exempts the interest income from qualiﬁed municipal bond issuesfrom taxation at the federal level. Municipal bonds are securities issued by
state and local governments and by their creations, such as “authorities” and
special districts. The tax-exempt feature of municipal bonds is an attractive
feature to an investor because it reduces taxes and, therefore, the spread

is often such that the municipal bond issue sells in the market at a lowerinterest rate than a comparable-maturity bond issue.
For example, on August 5, 2008 ﬁnance.yahoo.com reported (based on
information supplied by ValuBond) that the ﬁve-year Treasury yield was3.29% and the yield on ﬁve-year municipal bonds was as follows: AAA-
rated bonds 2.95%, AA rated bonds 3.04%, and A rated bonds 3.27%.
When comparing the yield on a municipal bond issue to that of the yield

on a comparable-maturity Treasury issue, the market convention is not tocompute the basis point difference (i.e., the spread) between the two bond
issues. Instead, the market convention is to compute the ratio of the yieldof a municipal bond issue to the yield of a comparable-maturity Treasury

The Structure of Interest Rates 475
security. The resulting ratio is the municipal yield ratio or the muni-Treasury
yield ratio:
RatingYield
August 5,
2008Muni-Treasury
Yield Ratio
AAA rated 2.95% 0.90
AA rated 3.04% 0.92
A rated 3.27% 0.99
In selecting between a taxable bond (such as a corporate bond) and a
municipal bond with the same maturity and credit rating, an investor can

calculate the yield that must be offered on a taxable bond issue to give the
same after-tax yield as a municipal bond issue. This yield measure is called
theequivalent taxable yield and is determined as follows:
Equivalent taxable yield =Tax-exempt yield
(1−Marginal tax rate)
For example, suppose an investor is considering the purchase of an AA
rated ﬁve-year municipal bond on August 5, 2008 offering a yield of 3.04%(the tax-exempt yield). Then
Equivalent taxable yield =0.0304
(1−0.35)=4.677%

That is, for an investor in the 35% marginal tax bracket, a taxable bondwith a 4.677% yield would provide the equivalent of a 3.04% tax-exemptyield.
TRY IT! EQUIVALENT TAXABLE YIELD
Tax-ExemptYieldMarginal
Tax RateEquivalent
Taxable Yield
5% 40%
4% 45%
6% 30%

476 INVESTMENTS
Expected Liquidity of a Bond Issue
When an investor wants to sell a particular bond issue, he or she is concerned
whether the price that can be obtained from the sale will be close to the
“true” value of the issue. For example, if recent trades in the market for

a particular bond issue have been between 87.25 and 87.75 and marketconditions have not changed, an investor would expect to sell the bond
somewhere in the 87.25 to 87.75 range.
The concern that the investor has when contemplating the purchase of
a particular bond issue is that he or she will have to sell it below its truevalue where the true value is indicated by recent transactions. This risk
is referred to as liquidity risk. The greater the liquidity risk that investors

perceive there is with a particular bond issue, the greater the spread or riskpremium relative to a comparable-maturity Treasury security. The reason isthat Treasury securities are the most liquid securities in the world.
THE TERM STRUCTURE OF INTEREST RATES
The price of a debt instrument will ﬂuctuate over its life as yields in the
market change. The price volatility of a bond depends on its maturity, among

other things. Holding all other factors constant, the longer the maturity ofa bond the greater is the price volatility resulting from a change in market
interest rates. The spread between any two maturities in a sector of a market
is the maturity spread. Although we can calculate this spread for any sector
of the market, it is most commonly calculated for the Treasury sector.
The relationship between the yields on comparable securities but differ-

ent maturities is the term structure of interest rates. Again, the primary focus
is the Treasury market. The graphic that depicts the relationship between
the yields on Treasury securities with different maturities is known as the
yield curve and, therefore, we also refer to the maturity spread as the yield
curve spread .
We show three hypothetical Treasury yield curves in Exhibit 18.2.
Though we have observed all three types in the U.S., the predominant type
is the upward sloping yield curve.

The Treasury yield curve plays the role as a benchmark for setting
yields in many other sectors of the debt market. However, a Treasury yieldcurve based on observed yields on the Treasury market is an unsatisfactory
measure of the relation between required yield and maturity. The key reasonis that securities with the same maturity may actually provide different yields.
Hence, it is necessary to develop more accurate and reliable estimates of

the Treasury yield curve. Speciﬁcally, the key is to estimate the theoretical

The Structure of Interest Rates 477
Yield
Yield
YieldUpward
sloping
Downwardsloping
Maturity
(A)Maturity
(B)
Maturity
(C)Flat
EXHIBIT 18.2 Three Observed Shapes for the Yield Curve
interest rate that the U.S. Treasury would have to pay assuming that thesecurity it issued is a zero-coupon security. Due its complexity, we will not

explain how this is done. However, at this point all that is necessary to
know is that there are procedures for estimating the theoretical interest rateor yield that the U.S. Treasury would have to pay for bonds with different
maturities. These interest rates are referred to as the Treasury spot rates.
We can obtain valuable information for market participants from the
Treasury spot rates. These rates are forward rates . Let’s see how we ob-

tain these rates and then we will discuss theories about what determines
forward rates.
Forward Rates
Consider the following two Treasury spot rates: the spot rate for a zero-
coupon Treasury security maturing in one year is 4% and the spot rate for
a zero-coupon Treasury security maturing in two years is 5%. Let’s look at

478 INVESTMENTS
this situation from the perspective of an investor who wants to invest funds
for two years. The investor’s choices are as follows:
Alternative 1. Investor buys a two-year zero-coupon Treasury security.
Alternative 2. Investor buys a one-year zero-coupon Treasury security
and when it matures in one year the investor buys another one-year
instrument.

With Alternative 1, the investor will earn the two-year spot rate and
that rate is known with certainty: 5%. In contrast, with Alternative 2, the
investor will earn the one-year spot rate, 4%, but the one-year spot oneyear from now is unknown. Therefore, for Alternative 2, the rate that will
be earned over the two-year planned investment period is not known with
certainty.
1
Putting the numbers to this,
Alternative 1: Annual return =5%
Alternative 2: Annual return =√
(1+0.04)(1 +f)

where fis the unknown one-year spot rate one year from today.
Suppose that this investor expects that one year from now the one-
year spot rate will be higher than it is today. The investor might then feel
Alternative 2 would be the better investment. However, this is not necessarily
true. To understand why it is necessary to know what the forward rate is,
let’s continue with our illustration.

The investor will be indifferent to the two alternatives if they produce
the same total dollars over the two-year investment horizon. Given the two-year spot rate, there is some spot rate on a one-year zero-coupon Treasurysecurity one year from now that will make the investor indifferent between
the two alternatives.
We can determine the value of fgiven the two-year spot rate and the
one-year spot rate by solving for the rate fsuch that the investment in

1Alternative 2 uses the calculation of the geometric mean return. For two periods,
with r1the rate in the ﬁrst period and r2the expected rate in the second period,
the two-year rate is the average annual return over the two periods, which is the
square root of (1 +r1)(1+r2), or two-year rate =2√
(1+r1)(1+r2). Therefore, in
Alternative 2 we solve for the one-year rate expected one year from now based on
the two-year return and the one-year return in the ﬁrst period.

The Structure of Interest Rates 479
the two-year security at 5% is equivalent to an investment in a one-year
investment at 4% and a subsequent one-year investment at the rate f:
(1+0.05)2=(1+0.04)(1 +f)
Using a bit of algebra to solve for f,
(1+f)=(1+0.05)2
(1+0.04)
f=6.01%
We can check our work to see if both alternatives provide the same

number of dollars at the end of the two-year investment horizon:
■Alternative 1: If an investor placed $100 in the two-year zero-coupon
Treasury security earning 5%, the total dollars that at the end of two
years is $100 ×(1.05)2=$110.25.
■Alternative 2: The proceeds from investing in the one-year Treasury
security at 4% generates $104 at the end of the ﬁrst year. Investing thisfor the next period at 6.01% produces an end of period value of $104
×(1+0.0601) =$110.25.

Here is how we use this forward rate of 6.01%. If the one-year spot
rate one year from now is less than 6.01%, then the total dollars at theend of two years would be higher by investing in the two-year zero-couponTreasury security (Alternative 1). If the one-year spot rate one year from
now is greater than 6.01%, then the total dollars at the end of two years
would be higher by investing in a one-year zero-coupon Treasury security

and reinvesting the proceeds one year from now at the one-year spot rate at
that time (Alternative 2). Of course, if the one-year spot rate one year fromnow is 6.01%, the two alternatives give the same total dollars at the end of
two years.
Now that we have the forward rate, f,in which we are interested and
we know how that rate can be used, let’s return to the question that weposed at the outset. Suppose the investor expects that one year from now,

the one-year spot rate one year from now will be 5.5%. That is, the investorexpects the one-year spot rate one year from now will be higher than its
current level. Should the investor select Alternative 2 because the one-year

480 INVESTMENTS
spot rate one year from now is expected to be higher? The answer is no,
because this produces a value less than investing at 5% for two years:
Investment value
at the end of two years =$100×1.40×1.055 =$109.72
In this example, if the spot rate in the second year is less than 6.01%,

then Alternative 1 is the better alternative. If this investor expects a rate of5.5%, then he or she should select Alternative 1 despite the fact that he or
she expects the one-year spot rate to be higher next year than it is today.
This is a somewhat surprising result for some investors. But the reason
for this is that the market prices its expectations of future interest ratesinto the rates offered on investments with different maturities. This is why

knowing forward rates is critical. Some market participants believe that the
forward rate is the market’s consensus of future interest rates.
Similarly, borrowers need to understand what is meant by a forward
rate. For example, suppose a borrower must choose between a two-yearloan and a series of two one-year loans. If the forward rate is less than the

borrower’s expectations of one-year rates one year from now, the borrowerwill be better off with a two-year loan. If, instead, the borrower’s expec-
tations are that the one-year rate one year from now will be less than the
forward rate, the borrower will be better off by choosing a series of twoone-year loans.
In practice, a company’s treasurer needs to know both forward rates and

future spreads. A company often pays the Treasury rate (i.e., the benchmark)plus a spread on its borrowings, so understanding current and future rates
is critical.
A natural question about forward rates is how well they do at predicting
future interest rates. Studies have demonstrated that forward rates do notdo a good job in predicting future interest rates. Then, why the big deal
about understanding forward rates? The reason, as we demonstrated in our

illustration of how to select between two alternative investments, is that the
forward rates indicate how an investor’s and borrower’s expectations mustdiffer from the market consensus, as measured by forward rates, in order to
make the correct decision.
In our illustration, the one-year forward rate may not be realized. That
is irrelevant. The fact is that the one-year forward rate indicated to theinvestor that if expectations about the one-year rate one month from now

are less than 6.01%, the investor would be better off with Alternative 1.
For this reason, as well as others explained later, some market partici-
pants do not refer to forward rates as being market consensus rates. Instead,they refer to forward rates as hedgeable rates. For example, by investing in

The Structure of Interest Rates 481
the two-year Treasury security, the investor was able to hedge the one-year
rate one year from now. Similarly, a corporation issuing a two-year securityis hedging the one-year rate one year from now.
TRY IT! FORWARD RATES

Complete the following table for the one-year rate one year from nowthat would make the investor indifferent between the two-year zero-
coupon security and two, successive one-year zero-coupon securities:
Case 2-Year Spot Rate 1-Year Spot RateOne-Year Rate One
Year from Now
A 5.00% 4.25%
B 2.25% 1.75%
C 3.00% 2.75%
D 4.00% 3.80%
Determinants of the Shape of the Term Structure
At a given point in time, if we plot the term structure—the yield to maturity,

or the spot rate, at successive maturities against maturity—we would observeone of the three shapes we show in Exhibit 18.2.
In Exhibit 18.3, we show a yield curve where the yield increases with
maturity. This type of yield curve is an upward-sloping yield curve or a
positively sloped yield curve . We provide four examples of upward-sloping
yield curves in Panel A of Exhibit 18.4.
We distinguish upward sloping yield curves based on the steepness of the

yield curve. The steepness of the yield curve is typically measured in terms ofthe maturity spread between long-term and short-term yields. While thereare many maturity candidates to proxy for long-term and short-term yields,
many market participants use the maturity spreads between the 30-year yield
and six-month yield. Consider the upward sloping curves in Exhibit 18.3for June 12, 1991 and January 1, 2010. The spread between the 30-year

and six-month yields are 248 basis points and 461 basis points, respectively.
Therefore, we would conclude that the yield curve in January 2010 is steeperthan that of June 1991.
In practice, we refer to a Treasury positively sloped yield curve whose
maturity spread as measured by the 30-year yields and six-month yields as

482 INVESTMENTS
6/12/1991 1/11/2010 5/23/2007 1/2/2001 11/20/2000
0%1% 2%3%4%5%6%7%8%9%
3 mos.
1 yr.
2 yrs.
3 yrs.
5 yrs.
7 yrs.
10 yrs.
20 yrs.
30 yrs.6/12/1991 1/11/2010 5/23/2007 1/2/2001 11/20/2000
EXHIBIT 18.3 Four Observed Actual Yield Curves
Source: U.S. Treasury.
a normal yield curve when the spread is 300 basis points or less. The yield

curve on June 12, 1991 is therefore a normal yield curve. When the maturityspread is more than 300 basis points, the yield curve is said to be a steep
yield curve. The yield curve on January 11, 2010 is a steep yield curve.
We also provide two examples of downward-sloping or inverted yield
curves , where yields in general decline as maturity increases: November 20,
2000 and January 2, 2001. There have not been many instances in the

recent history of the U.S. Treasury market where the yield curve exhibitedthis characteristic. We provide additional examples in Exhibit 18.4, Panel
B. The most notable is on August 14, 1981, when Treasury yields were
at a historic high. The yield on the two-year Treasury was 16.91% and
declined for each subsequent maturity until it reached 13.95% for the 30-
year maturity.
We also show a ﬂat yield curve from May 23, 2007 in Exhibit 18.3. For

a ﬂat yield curve, the yields are not identical for each maturity; rather, theyields for all maturities are similar. You can see additional examples of thistype of yield curve in Panel C of Exhibit 18.4.
A variant of the ﬂat yield curve is one in which the yield on short-term
and long-term Treasuries are similar but the yield on intermediate-termTreasuries are much lower than the six-month and 30-year yields. Such a
yield curve is referred to as a humped yield curve . We provide examples of

EXHIBIT 18.4 Examples of Actual Yield Curves
A: Upward sloping
Day 3 mos. 6 mos. 1 yr. 2 yrs. 3 yrs. 5 yrs. 7 yrs. 10 yrs. 20 yrs. 30 yrs. Spread
04/15/1992 3.70% 3.84% 4.14% 5.22% 5.77% 6.66% 7.02% 7.37% NA 7.87% 403 bp
02/05/2010 0.03 0.10 0.17 0.31 0.77 1.28 2.23 3.00 4.36 4.51 441 bp
B: Downward sloping

02/21/2007 5.18% 5.16% 5.05% 4.82% 4.74% 4.68% 4.68% 4.69% 4.90% 4.79% −37 bp
01/19/2007 6.33 6.15 6.46 6.4 6.31 6.35 6.16 6.29 5.92 6.33 18 bp
C: FlatDay 3 mos. 6 mos. 1 yr. 2 yrs. 3 yrs. 5 yrs. 7 yrs. 10 yrs. 20 yrs. 30 yrs. Spread
01/03/1990 7.89% 7.94% 7.85% 7.94% 7.96% 7.92% 8.04% 7.99% NA 8.04% 10 bp05/23/2007 4.91 5.01 4.96 4.85 4.79 4.79 4.80 4.86 5.09 5.01 0 bp
D: Humped

11/24/2000 6.34% 6.12% 5.86% 5.84% 5.63% 5.70% 5.63% 5.86% 5.67% 6.34% 22 bp
01/02/2000 5.87 5.58 5.11 4.87 4.82 4.76 4.97 4.92 5.46 5.35 −23 bp
Note:1. NA indicates no securities with that maturity for that date
2. The spread is the difference in basis points between the 30-year maturity and the 6-month maturity.
483

484 INVESTMENTS
TERM STRUCTURE OF INTEREST RATES THEORIES
There are two major economic theories that have evolved to account for the
observed shapes of the yield curve: the expectations theory and the market
segmentation theory .
Expectations Theories
There are two forms of the expectations theory: pure expectations theory

and biased expectations theory. Both theories share a hypothesis about the
behavior of short-term forward rates and also assume that the forward ratesin current long-term bonds are closely related to the market’s expectations
about future short-term rates.
The two theories differ, however, on whether or not other factors also af-
fect forward rates, and how. The pure expectations theory postulates that no
systematic factors other than expected future short-term rates affect forward

rates; the biased expectations theory asserts that there are other factors.
Pure Expectations Theory According to the pure expectations theory, the
forward rates exclusively represent the expected future rates. Thus, the entireterm structure at a given time reﬂects the market’s current expectations of thefamily of future short-term rates. Under this view, an upward-sloping yield
curve indicates that the market expects short-term rates to rise throughout

the relevant future. Similarly, a ﬂat term structure reﬂects an expectation thatfuture short-term rates will be mostly constant, while a falling term structure
must reﬂect an expectation that future short rates will decline steadily.
A major shortcoming of the pure expectations theory is that it ignores
the risks inherent in investing in debt instruments. If forward rates wereperfect predictors of future interest rates, then the future prices of bonds

would be known with certainty. The return over any investment period
would be certain and independent of the maturity of the debt instrument
initially acquired and of the time at which the investor needed to liquidatethe debt instrument. However, with uncertainty about future interest rates
and hence about future prices of bonds, these debt instruments become
risky investments in the sense that the return over some investment horizonis unknown.

Similarly, from a borrower’s perspective, the cost of borrowing for any
required period of ﬁnancing would be certain and independent of the matu-rity of the debt instrument if the rate at which the borrower must reﬁnance
debt in the future is known. But with uncertainty about future interest rates,

The Structure of Interest Rates 485
the cost of borrowing is uncertain if the borrower must reﬁnance at some
time over the period in which the funds are initially needed.
Biased Expectations Theory Biased expectations theories take into ac-
count the shortcomings of the pure expectations theory. The two theories
are the liquidity theory and the preferred habitat theory.

According to the liquidity theory , the forward rates will not be an un-
biased estimate of the market’s expectations of future interest rates becausethey embody a premium to compensate for risk; this risk premium is aliquidity premium . Therefore, an upward-sloping yield curve may reﬂect ex-
pectations that future interest rates will either rise, fall, or remain the same,but with a liquidity premium increasing fast enough with maturity so as toproduce an upward-sloping yield curve.

Thepreferred habitat theory also adopts the view that the term struc-
ture reﬂects the expectation of the future path of interest rates as well asa risk premium. However, the preferred habitat theory rejects the assertion
that the risk premium must rise uniformly with maturity. Instead, propo-
nents of the preferred habitat theory say that the latter conclusion couldbe accepted if all investors intend to liquidate their investment at the ﬁrst

possible date, while all borrowers are eager to borrow long. However, this
is an assumption that can be rejected for a number of reasons. The argumentis that different ﬁnancial institutions have different investment horizons and
have a preference for the maturities in which they invest. The preference is
based on the maturity of their liabilities. To induce a ﬁnancial institution out
of that maturity sector, a premium must be paid. Thus, the forward rates

include a liquidity premium and compensation for investors to move out oftheir preferred maturity sector. Consequently, forward rates do not reﬂect
the market’s consensus of future interest rates.
Market Segmentation Theory
Themarket segmentation theory also recognizes that investors have pre-
ferred habitats dictated by saving and investment ﬂows. This theory also
proposes that the major reason for the shape of the yield curve lies in

asset/liability management constraints (either regulatory or self-imposed)
and/or creditors restricting their lending or borrowers restricting their ﬁ-nancing to speciﬁc maturity sectors.
The market segmentation theory differs from the preferred habitat
theory because the market segmentation theory assumes that neither in-vestors nor borrowers are willing to shift from one maturity sector to an-
other to take advantage of opportunities arising from differences between

486 INVESTMENTS
expectations and forward rates. Thus, according to the market segmentation
theory, the shape of the yield curve is determined by the supply of and thedemand for securities within each maturity sector.
SWAP RATE YIELD CURVE

Another benchmark interest rate that is used by global investors is the swaprate. As explained in Chapter 14, in a generic interest rate swap the partiesexchange interest payments on speciﬁed dates: One party pays interest based
on a ﬁxed rate and the other party based on a ﬂoating rate over the life of
the swap. In a typical swap the ﬂoating rate is based on a reference rateand the reference rate is typically LIBOR. The ﬁxed interest rate that is paid

by the ﬁxed rate counterparty is the swap rate.
The relationship between the swap rate and maturity of a swap is the
swap rate yield curve, or more commonly the swap curve. Because the refer-
ence rate is typically LIBOR, the swap curve is also called the LIBOR curve.
The swap curve is used as a benchmark in many countries outside the
United States. Unlike a country’s government bond yield curve, however,the swap curve is not a default-free yield curve. Instead, it reﬂects the credit

risk of the counterparty to an interest rate swap. Because the counterparty
to an interest rate swap is typically a bank-related entity, the swap curve
reﬂects the average credit risk of representative banks that provide interestrate swaps. More speciﬁcally, a swap curve is viewed as the interbank yield
curve.I ti sa l s or e f e r r e dt oa st h eAA rated yield curve because the banks
that borrow money from each other at LIBOR have credit ratings of Aa/AAor above.

We see the effect of this credit risk when we compare the yield curve
based on U.S. Treasuries with the swap rate curve. For example, considerthe rates for August 22, 2008:
1 yr. 2 yrs. 3 yrs. 4 yrs. 5 yrs. 7 yrs. 10 yrs. 30 yrs.
Yield curve, U.S.
Treasuries2.15% 2.35% 2.62% NA 3.07% 3.39% 3.82% 4.44%
Swap curve 3.05% 3.38% 3.73% 3.95% 4.10% 4.36% 4.58% 4.92%
Spread in basis
points90 103 111 NA 103 97 76 48
The spread between these two curves ranges from 48 basis points for 30-year

The Structure of Interest Rates 487
There are reasons why investors prefer to use a country’s swap curve if it
available than a country’s yield curve obtained from its government bonds.2
■In ﬁnancial markets there is not one interest rate but rather a structure
of interest rates that is affected by various risk factors and tax factors.

Because a security’s value depends, in part, on the expected yield or rateof return investors want, the structure of interest rates affects the value
of a security.
■The base interest rate is the sum of the real interest rate and the expected
rate of inﬂation. Because securities issued by the U.S. Department of the
Treasury are backed by the full faith and credit of the U.S. government,
the interest rate on these securities is viewed as the base interest rate.

■An interest rate reﬂects the base interest rate and risk. The risk premiumis measured using the spread on the yields between a risky securityand that of a similar-maturity risk-free security, such as a U.S. Trea-
sury security. Factors that affect the risk premium include the market’s
perception of the credit risk of the non-Treasury security, any featuresof the non-Treasury security that make it attractive or unattractive to
investors, and the expected liquidity of the non-Treasury issue.

■The term structure of interest rates is the relationship between the yields
on comparable securities but different maturities. The yield curve is the
graphic that depicts this relationship. The yield curve spread measures
the difference in the yield between two maturities. Historically, the yieldcurve is normally upward sloping, reﬂecting higher yields for longer-
term securities, though ﬂat, humped, and downward sloping yield curves
have been observed.

■Forward rates can be extrapolated from the term structure of interest
rates to provide valuable information for borrowing strategies and in-
vesting strategies. A forward rate is the rate for a future time period.
Although market participants often state that forward rates are the mar-
ket’s consensus of future rates, the most useful way to think of theserates is as rates that can be locked in today (that is, hedgeable rates).

■There are two main theories that seek to explain the shape of the yieldcurve: expectations theory and market segmentation theory. There are
2For more information, see Uri Ron, “A Practical Guide to Swap Curve Con-
struction,” in Frank J. Fabozzi (ed.), Interest Rate, Term Structure, and Valuation
Modeling (Hoboken, NJ: John Wiley & Sons, 2002).

488 INVESTMENTS
two forms of the expectations theory: pure expectations theory and bi-
ased expectations theory. The theories seek to explain the behavior ofshort-term forward rates and also assume that the forward rates in cur-
rent long-term bonds are closely related to the market’s expectations

about future short-term rates. The two theories as to the extent thatfactors other than the market’s expectations theory, also affect forward
rates, and how. According to the pure expectations there are no sys-
tematic factors other than expected future short-term rates that affectforward rates; the biased expectations theory asserts that there are other
factors such as liquidity (liquidity theory) and the preferred maturity

sector of investors (preferred habitat theory). The market segmentationtheory assumes that neither investors nor borrowers are willing to shift
from one maturity sector to another to take advantage of opportunities
arising from differences between expectations and forward rates.
■Another benchmark interest rate used by global investors is the swaprate. The relationship between the swap rate and maturity of a swapis the swap rate yield curve or swap curve. These rates do not reﬂect

default-free rates but rather reﬂect the average risk of banks that are
involved in interest rate swaps.
Credit Spreads
AAA rated 4.92% 119
AA rated 5.43% 170
A rated 5.90% 217
BBB rated 6.32% 259
Equivalent Taxable Yields
Tax-Exempt
YieldMarginal
Tax
RateEquivalent
Taxable
Yield
5% 40% 8.33%
4% 45% 7.27%
6% 30% 8.57%

The Structure of Interest Rates 489
Case 2-Year Rate 1-Year RateOne-Year Spot Rate
One Year from Now
A 5.00% 4.25% 5.76%
B 2.25% 1.75% 2.75%
C 3.00% 2.75% 3.25%
D 4.00% 3.80% 4.20%
QUESTIONS
1.What is the base interest rate?
2.Suppose the yield on a 10-year corporate bond is 6.2% and the yield on

a similar-maturity Treasury security is 4.5%.a.What is the yield spread for this corporate bond?
b.Why is there a yield spread between these two securities?
3.How does a conversion provision on a debt obligation provide an optionto the investor?
4.If the yield on a Treasury security is 3% and that of a similar-maturitymunicipal bond is 2.5%, what is the muni-Treasury yield ratio for this
municipal bond?
5.Explain the relation between a tax-exempt yield and a taxable yield for

bonds with similar maturity and features.
6.What is a maturity spread?
7.If a three-year security has a yield of 5%, and a two-year Treasurysecurity has a yield of 4.5%, what is the one-year forward rate two
years from now?
8.What is the shape of the normal yield curve?
9.List the possible explanations for observed yield curves.
10.What is the relevance of the swap rate curve?
11.Typically, how do market participants gauge the credit risk associated
with a bond issue?

12.What is the relationship between credit risk and the risk premium?
13.Suppose that the one-year spot rate is 4.1% and the two-year spot rateis 4.6%. What is the one-year forward rate one year from now?
14.Complete the following table:
2-Year Spot Rate 1-Year Spot Rate 1-Year Forward Rate
5% 4%
4% 3.8%
3.5% 3.25%

490 INVESTMENTS
15.Comment on the following statement: “Forward rates are good predic-
tors of future interest rates.”
16.Why can forward rates be viewed as hedgeable rates?
17.Consider the following yields to maturity:
Years to Maturity Yield to Maturity
13 .0%
23 .5%
33 .9%
44 .4%
54 .8%
65 .2%
a.Graph the yield to maturity against the time to maturity.

b.Is this yield curve consistent with any of the yield curve theories?Explain.
18.A corporate treasurer is considering borrowing funds for 10 years. Howcan the corporate treasurer use forward rates in determining whether toborrow today or postpone borrowing?
19.Why are “biased” expectation theories of the term structure of interestrates biased?
20.Comment on the following: “There is no theory of the term structure
of interest rates that would explain a yield curve in which interest rates

increase with maturity for the ﬁrst two years, decline with maturity until
year 5, and then increase with maturity after year 5.”

c19 JWBT310-Fabozzi July 1, 2010 21:40 Printer: Courier Westford, Westford, MA
CHAPTER19
Valuing Common Stock
During the 20th Century, the Dow advanced from 66 to 11,497.
This gain, though it appears huge, shrinks to 5.3% when
compounded annually. An investor who owned the Dow
throughout the century would also have received generousdividends for much of the period, but only about 2% or so in the
ﬁnal years. It was a wonderful century.

Berkshire Hathaway, February 2008, p. 19
In this chapter, we discuss practical methods of valuing common stockusing two methods: discounted cash ﬂow models and relative valuation
models. Both methods require strong assumptions and expectations about
the future. No one single valuation model or method is perfect. All valuation
estimates are subject to model error and estimation error. Nevertheless,

investors use these models to help form their expectations about a fair marketprice.
DISCOUNTED CASH FLOW MODELS
If an investor buys a common stock, he or she has bought shares that repre-
sent an ownership interest in the corporation. Shares of common stock are
a perpetual security—that is, there is no maturity. The investor who ownsshares of common stock has the right to receive a certain portion of any
∗The section on relative valuation is coauthored with Glen Larsen.
491

492 INVESTMENTS
cash dividends—but dividends are not a sure thing. Whether or not a corpo-
ration pays dividends is up to its board of directors—the representatives ofthe common shareholders. Typically, we see some pattern in the dividends
companies pay: Dividends are either constant or grow at a constant rate.
But there is no guarantee that dividends will be paid in the future.

It is reasonable to ﬁgure that what an investor pays for a share of stock
should reﬂect what he or she expects to receive from it—a return on theinvestor’s investment. What an investor receives are cash dividends in thefuture. How can we relate that return to what a share of common stock is
worth? Well, the value of a share of stock should be equal to the present value

of all the future cash ﬂows an investor expects to receive from that share.To value stock, therefore, an investor must project future cash ﬂows, which,
in turn, means projecting future dividends. This approach to the valuation
of common stock is referred to the discounted cash ﬂow approach.
There are various discounted cash ﬂow (DCF) models that we can use

to value common stock. We will not describe all of the models. Ratherour primary focus is on models that are referred to as dividend discount
models.
Dividend Discount Models
Most dividend discount models (DDM) use current dividends, some measure
of historical or projected dividend growth, and an estimate of the required
rate of return. Popular models include the basic dividend discount model that
assumes a constant dividend growth and the multiple-phase models. Here

we discuss these dividend discount models and their limitations, beginningwith a review of the various ways to measure dividends. Then we look at
how dividends and stock prices are related.
Dividend Measures Dividends are measured using three different metrics:
dividends per share, dividend yield, and dividend payout ratio. The value
of a share of stock today is the investors’ assessment of today’s worth of

future cash ﬂows for each share. Because future cash ﬂows to shareholdersare dividends, we need a measure of dividends for each share of stock to
estimate future cash ﬂows per share.
The dividends per share is the dollar amount of dividends paid out
during the period per share of common stock:
Dividends per share =Dividends paid to common shareholders
Number of shares of common stock outstanding

Valuing Common Stock 493
If a company has paid $600,000 in dividends to common sharehold-
ers during the period and there are 1.5 million shares of common stock
outstanding, then
Dividends per share =$600, 000
1,500, 000 shares=$0.40 per share
The company paid out 40 cents in dividends per common share during this
period.

period.
Another measure of dividends is the dividend yield , which is the ratio
of dividends to the common stock’s current price:
Dividend yield =Annual cash dividends per common share
Market price per common share
We also refer to the dividend yield as the dividend-price ratio.1
Still another way of describing dividends paid out during a period is
to state the dividends as a portion of earnings for the period. This is the
dividend payout ratio:

Dividend payout ratio =Dividends paid to common shareholders
Earnings available to common shareholders
If a company pays $360,000 in dividends to common shareholders and
has earnings available to common shareholders of $1.2 million, the dividendpayout ratio is 30%:
Dividend payout ratio =$360, 000
$1,200,000=0.30 or 30%
This means that the company paid out 30% of its earnings to common
shareholders.2
The proportion of earnings paid out in dividends varies by company

and industry. If the board of directors of a company focuses on maintaininga constant dividend per share or a constant growth in dividends per share
in establishing their dividend policy, the dividend payout ratio will ﬂuctuatealong with earnings. We generally observe that corporate boards set the
1Historically, the dividend yield for U.S. stocks has been a little less than 5% accord-
ing to a study by John Y. Campbell and Robert J. Shiller, “Valuation Ratios and

the Long-Run Stock Market Outlook,” Journal of Portfolio Management 24(1998):
11–26.
2The complement to the dividend payout ratio is the plowback ratio, which is the
percentage of earnings retained by the company during the period.

494 INVESTMENTS
dividend policy such that dividends per share grow at a relatively constant
rate, resulting in dividend payouts that ﬂuctuate from year to year.
What is the present value of the future dividend? The quoted price
of the ordinary stock at the end of 1873 is the sale value. Is that

the mathematical value? This value can only be estimated fromprospective dividends, which will turn upon the difference between
the income and the outgo through a series of years.
—William Farr, “On the Valuation of Railways Telegraphs,
Water Companies, Canals, and other Commercial Concerns,
with Prospective, Deferred, Increasing, Decreasing, or
Terminating Proﬁts,” Journal of the Royal Statistical Society,
1876, p. 476
TRY IT! DIVIDEND MEASURES
Calculate the:
1.Dividends per share

2.Dividend payout ratio, and
3.Dividend yield,
for each of the following companies:
CompanyCash
Dividends to
Common
ShareholdersNumber of
Shares of
Common Stock
OutstandingEarnings
Available to
Common
ShareholdersCurrent
Price per
Share
P $40,000 100,000 $200,000 $20
Q $800,000 200,000 $4,000,000 $40
R $250,000 250,000 $750,000 $15
S $5,000 10,000 $25,000 $10
Basic Dividend Discount Models

As discussed, the basis for the dividend discount model is simply the appli-
cation of present value analysis, which asserts that the fair price of an asset

Valuing Common Stock 495
is the present value of the expected cash ﬂows.3The cash ﬂows are the ex-
pected dividends per share. We can express the basic DDM mathematically
as:
P0=D1
(1+r1)1+D2
(1+r2)2+D3
(1+r3)3+···
or,
P0=∞∑
t=1Dt
(1+rt)t(19.1)
where: P0is the current price of the stock,
Dtis the dividend per share in period t, and

rtis the discount rate appropriate for the cash ﬂow in period t.
In this model, we expect to receive dividends. If investors never expected
a dividend to be paid, this model implies that the stock would have no value.To reconcile the fact that stocks not paying a current dividend do, in fact,have a positive market value with this model, we must assume that investors
expect that someday, at some time N, the company must pay out some cash,

even if only a liquidating dividend.
The Finite-Life General Dividend Discount Model We can modify the DDM
given by equation (19.1) by assuming a ﬁnite life for the expected cash ﬂows.
In this case, the expected cash ﬂows are the expected dividends per share
and the expected sale price of the stock at some future date. We refer to this
expected price in the future as the terminal price, and it captures the futurevalue of all subsequent dividends. This model is the ﬁnite-life general DDM

and which we can express mathematically as:
P
0=D1
(1+r2)2+···+PN
(1+rN)N
or
P0=[N∑
t=1Dt
(1+rt)t]
+PN
(1+rN)N
where PNis the expected value of the stock at the end of period N.
3This model was ﬁrst suggested by John Burr Williams, The Theory of Investment
Value (Boston, MA: Harvard University Press, 1938).

496 INVESTMENTS
Assuming a Constant Discount Rate A special case of the ﬁnite-life general
DDM that is more commonly used in practice assumes that the discount rate
is constant. That is, we assume each rtis the same for all t. Denoting this
constant discount rate by r, the value of a share of stock today becomes:
P0=D1
(1+r)1+D2
(1+r)2+···+PN
(1+r)N
or
P0=[N∑
t=1Dt
(1+r)t]
+PN

(1+r)N
or
P0=[N∑
t=1Dt
(1+r)t]
+PN
(1+r)N(19.2)
Equation (19.2) is the constant discount rate version of the ﬁnite-life generalDDM, and is the more general form of the model.
Let’s illustrate the ﬁnite life general DDM based on a constant discount
rate, assuming each period is a year. Suppose that an investor makes thefollowing estimates and assumptions for stock XYZ:
■Required rate of return of 10%.
■Current dividend of $2 per share.
■Growth in dividends of 4% per year.

■Expected price of the stock at the end of four years is $29.835.
Based on these data, the fair price of stock XYZ is
P0=$2.08
(1+0.10)1+$2.16
(1+0.10)2+$2.25
(1+0.10)3+$2.34
(1+0.10)4+$29.835
(1+0.10)4
=$27.34
The expected price today, $27.34, is our estimate of the value of a share of
the stock based on our estimates and assumptions.
If a little money does not go out, great money will not come in.
—Confucius, philosopher

Required Inputs The ﬁnite-life general DDM requires three sets of forecasts
as inputs to calculate the fair value of a stock:
■Expected terminal price, PN;
■Dividends up to the assumed horizon, D1toDN, and
■Discount rates, r1torN,o rr in the case of the constant discount rate
version.
Thus, the relevant issue is how accurately these inputs can be forecasted.

Valuing Common Stock 497
The terminal price is the most difﬁcult of the three forecasts. According
to theory, PNis the present value of all future dividends after N; that is,
DN+1,DN+2,...,D∞.Also, we must estimate the discount rate, r. In prac-
tice, we make forecasts of either dividends ( DN) or earnings (E N) ﬁrst, and

then the price PNbased on an “appropriate” requirement for yield, price-
earnings ratio, or capitalization rate. Note that the present value of the
expected terminal price PN÷(1+r)Nbecomes very small if Nis very large.
The forecasting of dividends is somewhat easier. Usually, information
on past dividends is readily available and we can estimate cash ﬂows fora given scenario. The discount rate ris the required rate of return, and

forecasting this rate is more complex. In practice for a given company, we
assume that ris constant for all periods, and typically estimate this rate from
the capital asset pricing model (CAPM). We can use the CAPM to estimatethe expected return for a company based on the expected risk-free rate, the
expected market risk premium, and the stock’s systematic risk, its beta.
4
EXAMPLE 19.1: ESTIMATING THE DISCOUNT RATE
Consider three companies, A, B, and C. Suppose that

■The market risk premium is 5%, and
■The risk-free rate is 4.63%.
The beta estimate for each company is:
Company Beta
A0 .9
B1 .0
C1 .2
The discount rate, r, for each company based on the CAPM is
therefore:
Company Beta Calculation Discount Rate
A 0.9 0.0463 +(0.9×0.05) 9.13%
B 1.0 0.0463 +(1.0×0.05) 9.63%
C 1.2 0.0463 +(1.2×0.05) 10.63%
4Using the CAPM, the expected return is the sum of the risk-free rate of interest and

a premium for bearing risk. The premium for bearing risk of a speciﬁc asset is the
product of the asset’s beta and the market’s risk premium.

498 INVESTMENTS
Assessing Relative Value Once we have an estimate of a stock’s value
from using the DDM, where do we go from there? We then compare our
estimate of the stock’s value with the observed price of the stock, if this price
is readily available. If the market price is below the fair price derived from

the model, the stock is undervalued or cheap. The opposite holds for a stockwhose market price is greater than the model-derived price. In this case, the
stock is said to be overvalued or expensive. A stock trading equal to or close
to its fair price is fairly valued.
The use of the DDM tells us the relative value but does not tell us when

the price of the stock should be expected to move to its fair price. That is, themodel says that based on the inputs generated by the investor, the stock maybe cheap, expensive, or fair. However, it does not tell us that if it is mispriced
how long it will take before the market recognizes the mispricing and corrects
it. As a result, an investor may hold onto a stock perceived to be cheap for
an extended period of time and may underperform during that period.

While a stock may be mispriced, an investor must also consider how
mispriced it is in order to take the appropriate action (that is, buy a cheapstock and expect to sell it when the price rises, or sell short an expensive
stock expecting its price to decline). This will depend on by how muchthe stock is trading from its fair value and transaction costs. An investor
should also consider that a stock may look as if it is mispriced (based on the

estimates and the model), but this may be the result of estimates and the useof these estimates in the model may introduce error in the valuation.
Constant Growth Dividend Discount Model If we assume that future div-
idends grow at a constant rate, g, and we use a single discount rate, r,t h e
ﬁnite-life general DDM assuming a constant growth rate given by equation
(19.2) becomes:
P
0=D0(1+g)1
(1+r)1+D0(1+g)2
(1+r)2+···+D0(1+g)N
(1+r)N+PN
(1+r)N

(1+r)N+PN
(1+r)N
It can be shown that if Nis assumed to approach inﬁnity, this equation
is equal to:
P0=D0(1+g)
r−g(19.3)
Equation (19.3) is the constant growth dividend discount model .5Therefore,
the greater the expected growth rate of dividends, the greater the estimated
value of a share of stock.
5Myron Gordon and Eli Shapiro, “Capital Equipment Analysis: The Required Rate
of Proﬁt,” Management Science 3 (1956): 102–110.

Valuing Common Stock 499
How do we estimate g? If we believe that dividends will grow in the
future at a similar rate as they grew in the past, we can estimate the dividend
growth rate by using the compounded rate of growth of historical dividends.
The compound growth rate, g, is found using the following formula:6
g=⎛
⎝Number
of years√
Last year’s dividend

g=⎛
⎝Number
of years√
First year’s dividend⎞⎠−1 (19.4)
Let’s estimate the value of a stock, using the past growth as our best
estimate of the future growth of dividends. Suppose a company paid $1.50
in dividends in 20X1 and paid $2.00 in dividends in 20X5. Using the time
value of money mathematics, the 20X5 dividend is the future value, the

starting dividend is the present value, and the number of years is the numberof periods; solving for the interest rate produces the growth rate.
Substituting the values for the starting and ending dividend amounts
and the number of periods into the formula, we get:
g=⎛
⎝
4√
$2.00
$1.50⎞⎠−1=7.457%
If the discount rate, r, for this company’s dividends is 15%, the value of
a share of stock in 20X5 is:
P
0=$2.00(1 +0.07457)
0.15−0.07457=$2.14914
0.07543=$28.49

Keep in mind that we are valuing this stock as of 20X5, which means that
the numerator in this valuation equation is the expected dividend in 20X6,which is the 20X5 dividend multiplied by 1 +g.
What if you estimate a stock’s value and the estimated value is consid-
erably off the mark when compared to the stock’s actual price? The reasons
for this discrepancy may include:

■The market’s expectations of the company’s dividend growth patternmay not be for constant growth; and
■The growth rate of dividends in the past may not be representative of
what investors expect in the future.
6This formula is equivalent to calculating the geometric mean of 1 plus the percentage
change over the number of years.

500 INVESTMENTS
Another problem that arises in using the constant growth rate model is
that the estimated growth rate of dividends may exceed the discount rate,
r. Therefore, there are some cases in which it is inappropriate to use the
constant rate DDM.
TRY IT! THE CONSTANT GROWTH MODEL

Estimate the value of a share of stock for each of the following com-panies using the constant growth model and estimating the average
annual growth rate of dividends from 20X1 through 20X6 as givenbelow as the basis for estimated growth beyond 20X6:
CompanyDividendsper Share,
20X1Dividendsper Share,
20X6Discount
Rate
1 $1.00 $1.20 8%
2 $2.00 $1.80 9%
3 $0.50 $0.60 7%
4 $0.25 $0.30 12%
Multiphase Dividend Discount Models The assumption of constant growth

may be unrealistic and can even be misleading. Instead, most practitioners
modify the constant growth DDM by assuming that companies will go
through different growth phases, but within a given phase, it is assumedthat dividends grow at a constant rate.
7
The most popular multiphase model employed by practitioners appears
to be the three-stage DDM . This model assumes that all companies go
through three phases, analogous to the concept of the product life cycle.

In the growth phase, a company experiences rapid earnings growth as it
produces new products and expands market share. In the transition phase
7For a pioneering work that modiﬁed the DDM to accommodate different growth
rates, see Nicholas Molodovsky, Catherine May, and Sherman Chattiner, “Common
Stock Valuation—Principles, Tables, and Applications,” Financial Analysts Journal
21 (1965): 104–123.

Valuing Common Stock 501
the company’s earnings begin to mature and decelerate to the rate of growth
of the economy as a whole. At this point, the company is in the matu-rity phase in which earnings continue to grow at the rate of the general
economy.
We can design a three-phase model to ﬁt different growth patterns. For

example, an emerging growth company would have a longer growth phasethan a more mature company. Some companies are considered to have higher
initial growth rates and hence longer growth and transition phases. Othercompanies may be considered to have lower current growth rates and hence
shorter growth and transition phases.
Do you know how to mark tangible assets to their true market

value or implement a multistage dividend discount model? Probablynot. Why should you? Most people also don’t know how to do a
coronary bypass or operate a backhoe. That why you hire someone
who does.
—Ken Gregory and Steve Savage, “Why We Prefer Funds,”
Kiplinger’s, August 2002, p. 59
Expected Returns and Dividend Discount Models
Thus far, we have seen how to calculate the fair price of a stock given the
estimates of dividends, discount rates, terminal prices, and growth rates.8We

then compare the model-derived price to the actual price and the appropriateaction is taken.
We can recast the model in terms of expected return. This is found
by calculating the interest rate that will make the present value of the ex-pected cash ﬂows equal to the market price. Mathematically, we can express
this as:
r=D
0(1+g)
P0+g=D1
P0+g (19.5)
In other words, the expected return is the discount rate that equates
the present value of the expected future cash ﬂows with the present value

8The formula for this model can be found in Eric Sorensen and Williamson, “Some
Evidence of the Value of Dividend Discount Models,” Financial Analysts Journal
41 (1985): 60–69.

502 INVESTMENTS
of the stock. The higher the expected return—for a given set of future cash
ﬂows—the lower the current value.
This rearrangement of the dividend discount model provides a perspec-
tive on the expected return: the expected return is the sum of the dividendyield (that is, D
1/P0) and the expected rate of growth of dividends. The latter

represents the appreciation (or depreciation, if negative) anticipated for the
stock. Therefore, this is the expected capital gain or loss (or, simply, capital
yield) on the stock.
Consider a company that currently pays a dividend of $1 per share, has
a current share price of $20, and dividends are expected to grow at a rateof 5% per year. Using this information, we estimate the discount rate as10.25%:
r=$1(1+0.05)
$20+0.05=$1.05
$20+0.05=10.25%

Given the expected return and the required return (that is, the value
forr), any mispricing can be identiﬁed. If the expected return exceeds the
required return, then the stock is undervalued; if it is less than the requiredreturn then the stock is overvalued. A stock is fairly valued if the expected
return is equal to the required return.
With the same set of inputs, the identiﬁcation of a stock being mispriced

or fairly valued will be the same regardless of whether the fair value isdetermined and compared to the market price or the expected return is
calculated and compared to the required return.
TRY IT! ESTIMATING THE EXPECTED RETURN
Estimate the expected return for each of the following companies:
CompanyCurrent
Dividends
per ShareExpected
Growth Rate
of DividendsCurrent Value
of the Stock
T $1.00 2% $25
U $0.50 3% $20
V $1.25 1% $10
W $0.25 2% $15

Valuing Common Stock 503
RELATIVE VALUATION METHODS
Although stock and company valuation is very strongly tilted toward the use
of DCF methods, it is impossible to ignore the fact that many investors use
other methods to value equity and entire companies. The primary alternative

valuation method is the use of multiples (that is, ratios) that have price orvalue as the numerator and some form of earnings or cash ﬂow generating
performance measure for the denominator and that are observable for other
similar or like-kind companies.
These multiples are sometimes called “price/X ratios,” where the denom-

inator “X” is the appropriate cash ﬂow generating performance measure.For example, the price/earnings (P/E) ratio is a popular multiple used forrelative valuation, where an earnings estimate is the cash ﬂow generating
performance measure. Keep in mind that the terms relative valuation and
valuation by multiples are used interchangeably here as are the terms price
and value.
The essence of valuation by multiples assumes that similar or compara-

ble companies are fairly valued in the market. As a result, the scaled priceor value (the present value of expected future cash ﬂows) of similar compa-
nies should be much the same. That is, comparable companies should havesimilar price/X ratios. The key is to ﬁnd the comparable companies that we
can use for valuing a target company using valuation by multiples.
Valuation by multiples, or simply relative valuation, is quick and con-

venient. The simplicity and convenience of valuation by multiples, however,constitute both the appeal of this valuation method and the problems asso-
ciated with its use. Simplicity, however, means that too many facts are sweptunder the carpet and too many questions remain unasked. Multiples should
never be an investor’s only valuation method and preferably not even the

primary focus because no two companies, or even groups of companies, areexactly the same. The term “similar” entails just as much uncertainty as the
concept of “expected future cash ﬂows” in DCF valuation methods. Actu-
ally, when an investor has more than ﬁve minutes to value a company, the
DCF method, which forces an investor to consider the many aspects of an
ongoing concern, is the preferred valuation method and the use of multiplesshould be secondary.

Having said this, valuation by multiples can provide a valuable “sanity
check.” If an investor has completed a thorough valuation, he can comparehis predicted multiples, such as the P/E ratio and market value to book
value (MV/BV) ratio, to representative multiples of similar companies. In
the MV/BV ratio, the book value of assets is the cash ﬂow generating per-formance measure. That is, each dollar of book value of assets is assumed

to generate cash ﬂow for the company. If an investor’s predicted multiples

504 INVESTMENTS
are comparable, he can, perhaps, feel more assured of the validity of his
analysis. On the other hand, if an investor’s predicted multiples are outof line with the representative multiples of the market, the investor should
re-examine the assumptions, the appropriateness of the comparables, and
the appropriateness of the multiple to the situation at hand.

When using relative valuation, an investor does not attempt to explain
observed prices of companies. Instead, an investor uses the appropriatelyscaled average price of similar companies to estimate values without spec-ifying why prices are what they are. That is, the average price of similar
companies is scaled by the appropriate “price/X” ratio. In addition, there is

nothing to say that multiple price/X ratios can be used or is appropriate forthe situation and that each one will generally provide a different estimate of
value. Hence, the trick in valuing with multiples is selecting truly compara-
ble companies and choosing the appropriate scaling bases—the appropriate
“X” measure.
The Basic Principles of Relative Valuation
To use the word “multiples” is to use a fancy name for market prices divided

(or “scaled”) by some measure of performance, a “Price/X” ratio where “X”
is the measure of performance that is highly correlated with cash ﬂow. In
a typical valuation with multiples, the average multiple—the average pricescaled (divided) by some measure of performance—is applied to a perfor-
mance measure of the target company that an investor is attempting to value.
For example, suppose an investor chooses earnings as the scaling mea-

sure; that is, the investor chooses earnings to be the performance measure bywhich prices of similar companies will be scaled. To scale the observed prices
of companies by their earnings, the investor computes for each company theratio of its price to its earnings—its P/E ratio or its earnings multiple. He
then averages the individual P/E ratios to estimate a “representative” P/E
ratio, or a representative earnings multiple. To value a company, the in-

vestor multiplies the projected proﬁts of the company being valued by the
representative earnings multiple, the average P/E.
When valuing with multiples, the investor is agnostic regarding what
determines prices. This means that there is no theory to guide the investoron how best to scale observed market prices by one of the following: netearnings, earnings before interest and taxes (EBIT), sales, or book value of
assets. In practice, this means that valuation with multiples requires the use

of several scaling factors or, in other words, several multiples.
Often the best multiples for one industry may not be the preferred
multiples in another industry. This implies, for example, that the practiceof comparing P/E ratios of companies in different industries is problematic

Valuing Common Stock 505
Choose comparable
companies
Value of the
companyApply the multiple
to the subject
company’s baseEstimate the base of
the multiple for the
subject companyDetermine the
appropriate multipleCalculate the multiple
for the comparable
companies
EXHIBIT 19.1 The Process of Relative Valuation
(and in many cases inappropriate altogether). This further implies that when

the investor performs a multiple-based valuation, it is important ﬁrst to ﬁndwhat the industry considers as the best measure of relative values.
Although valuation by multiples differs from valuation by discount-
ing cash ﬂows, its application entails a similar procedure—ﬁrst projectingperformance, and then converting projected performance to values using
market prices, as we detail in Exhibit 19.1.
Speciﬁcally, if an investor believes, based on a study of comparable

companies, that an appropriate forward-looking P/E (or any price/X ratio)for a subject company is 17 and expects earnings to be $3.00 per share in the
next period, an estimate of a fair market price based on relative valuationassumptions is:
Appropriate
P/Er a t i o×Expected
earnings=17×$3=$51 per share
Choose Comparable Companies

The whole idea is to estimate a value of the subject company using themultiple implicit in the pricing of the comparable companies. Therefore, wewant to select comparable companies that are as similar as possible to the
company being valued. The ﬂip side of this argument, however, is that by
specifying too stringent criteria for similarity, the investor ends up with toofew companies to compare. With a small sample of comparable companies,

the idiosyncrasies of individual companies affect the average multiples too
much so that the average multiple is no longer a representative multiple. In

506 INVESTMENTS
selecting the sample of comparable companies, the investor has to balance
these two conﬂicting considerations. The idea is to obtain as large a sampleas possible so that the idiosyncrasies of a single company do not affect the
valuation by much, yet not to choose so large a sample that the “comparable
companies” are not comparable to the one being valued.

Financial theory states that assets that are of equivalent risk should
be priced the same, all else equal. The key idea here is that we assume thatcomparable companies are of equivalent risk. Thus, the concept of being ableto ﬁnd comparable companies is the foundation for valuation by multiples.
If there are no comparable companies, then valuation by multiples is not
an option.
Determine an Appropriate Multiple

an option.
To convert market prices of comparable companies to a value for the com-pany being analyzed, an investor has to scale the valued company relative to
the comparable companies. This is typically done by using several bases of
comparison. Some generic measures of relative size often used in valuationby multiples are sales, gross proﬁts, earnings, and book values.
Often, however, industry-speciﬁc multiples are more suitable than

generic multiples. Examples of industry-speciﬁc multiples are price perrestaurant for fast-food chains, paid miles ﬂown for airlines, and price per
square foot of ﬂoor space for retailers. In general, the higher-up that the
scaling basis is in the income statement, the less it is subject to the vagaries
of accounting principles. Thus, scaling basis of sales is much less dependent

on accounting methods than earnings per share (EPS). For example, depreci-ation or treatment of convertible securities critically affect EPS calculations,
but hardly affect sales. On the other hand, the higher-up that the scaling basis
is in the income statement, the less it reﬂects differences in operating efﬁ-ciency across companies—differences that critically affect the values of the
comparable companies as well as the value of the company being analyzed.
Calculate the Multiple for the

Comparable Companies
Once an investor has a sample of companies that he is considering similar to
the company being valued, an average of the multiples provides a measure
of what investors are willing to pay for comparable companies in order to
estimate a “fair” price for the subject company. For example, after dividingeach comparable company’s share price by its EPS to get individual P/E
ratios, the investor can average the P/E ratios of all comparable companies

to estimate the earnings multiple that investors think is fair for companies

Valuing Common Stock 507
with these characteristics. The same thing can be done for all the scaling
bases chosen, calculating a “fair price” per dollar of sales, per restaurant,per square foot of retail space, per dollar of book value of equity, and so on.
Note that we put “fair price” in quotation marks: Because there is no

market for either EPS or sales or any other scaling measure, the computationof average multiples is merely a scaling exercise and not an exercise in ﬁnding
“how much the market is willing to pay for a dollar of earnings.” Investors
do not want to buy earnings; they only want cash ﬂows (in the form of eitherdividends or capital gains). Earnings (or sales) are paid for only to the extent
that they generate cash. In computing average ratios for various bases, we

implicitly assume that the ability of companies to convert each basis (e.g.,sales, book value, and earnings) to cash is the same. Keep in mind that this
assumption is more tenable in some cases than in others and for some scaling
factors than for others.
Realize that we use the term average to mean the appropriate value that
is determined by the average company in the comparable group. It may notbe the strict average. It may be a mean, median, or mode. The investor is

also free to throw out outliers that do not seem to conform to the majority
of companies in the group. Outliers are most likely so because the markethas determined that they are different for any number of reasons.
Estimate to Base of the Multiple for the
Subject Company
Once we have the multiple for the comparable, we apply it to the projected
performance of the company that we are valuing. Therefore, the investor
needs to project the same measures of the relative size used in scaling the

prices of the comparable companies for the company being valued.
Consider an example in which we want to value Company X, using
the comparables A, B, and C. And suppose we estimate the average P/E ofcompanies A, B, and C to be 15. If we project earnings per share of Company
X as $2, then applying the comparables’ multiple of 15 gives us an estimate
of the value per share for Company X of $30.
The simplest application of valuation with multiples is by projecting

the scaling bases one year forward and applying the average multiple ofcomparable companies to these projections. For example, the comparablecompanies’ average P/E ratio to the projected next year’s earnings of the com-
pany being valued is applied. Clearly, by applying the average multiple to the
next year’s projections, an investor overemphasizes the immediate prospectsof the company and gives no weight to more distant prospects.
To overcome this weakness of the one-step-ahead projections, we

can use a more sophisticated approach, applying the average multiples to

508 INVESTMENTS
representative projections—projections that better represent the long-term
prospects of the company. For example, instead of applying the averageP/E ratio to next year’s earnings, the comparable P/E ratio to the projected
average EPS over the next ﬁve years can be projected. In this way, the

representative earnings’ projections can also capture some of the long-termprospects of the company, while next year’s ﬁgures (with their idiosyncrasies)
do not dominate valuations.
Apply the Multiple to the Subject Company’s Base
In the ﬁnal step, an investor combines the average multiples of comparable
companies to the projected parameters of the subject company (i.e., the
company to be valued) to obtain an estimated value. On the face of it, this is

merely a simple technical step. Yet often it is not. The values that we obtainfrom various multiples (i.e., by using several scaling bases) are typically
not the same; in fact, frequently they are quite different. This means that
this step requires some analysis of its own—explaining why valuation bythe average P/E ratio yields a lower value than the valuation by the sales
multiple (e.g., the valued company has higher than normal selling, general,

and administrative expenses) or why the MV/BV ratio yields a relatively
TRY IT! RELATIVE VALUATION
Consider Company RV that has projected earnings per share of $2.5and a projected book value per share of $20. Determine the estimated
value of this Company RV, based on a relative value using:
■The price-earnings ratio, and
■The market value to book value ratio, and
using the average of the respective multiples of the comparables:
ComparableValue per
ShareEarnings
per ShareBook Value
per Share

per Share
X $15 $1 $10
Y $32 $2 $8
Z $60 $5 $40

Valuing Common Stock 509
low value. The combination of several values into a ﬁnal estimate of value,
therefore, requires an economic analysis of both “appropriate” multiplesand how multiple-based values should be adjusted to yield values that are
economically reasonable.
■The basis for the dividend discount model is simply the application of

present value analysis, which asserts that the fair price of an asset is the
present value of its expected cash ﬂows.
■Most dividend discount models use current dividends, some measure of
historical or projected dividend growth, and an estimate of the required
rate of return. The three most common dividend measures are dividends
per share, dividend yield, and dividend payout.
■Variations of the dividend discount models allow the investor to vary

assumptions regarding dividend growth to accommodate different pat-
terns of dividends. Popular models include the ﬁnite-life general dividenddiscount model, the constant growth dividend discount model, and the
multiphase dividend discount model.
■A dividend discount model can be recast in terms of expected return.
The expected return is found by calculating the interest rate that will
make the present value of the expected cash ﬂows be equal to the market
price.

price.
■An alternative valuation method to the dividend discount model is the
use of multiples that have price or value as the numerator and some
form of earnings or cash ﬂow generating performance measure for thedenominator and that are observable for other similar or like-kind com-
panies. These multiples are sometimes called “price/X ratios,” where the
denominator “X” is the appropriate cash ﬂow generating performance
measure.

measure.
■The essence of valuation by multiples assumes that similar or compa-
rable companies are valued fairly in the market. When using relative
valuation, no attempt is made by an investor to explain observed prices
of companies. Rather, an investor employs suitably scaled averageprices of similar companies to estimate values without specifying why
prices are what they are.
■Despite the fact that valuation by multiples differs from valuation by dis-

counting cash ﬂows, the application entails a similar procedure, which
involves ﬁrst forecasting performance, and then converting projected
performance to values using market prices.

510 INVESTMENTS
Dividend Measures
CompanyDividends
per ShareDividend
Payout RatioDividend
Yield
P $1.00 20% 2.00%
Q $1.00 20% 10.00%
R $1.00 33% 6.67%
S $1.00 20% 5.00%
The Constant Growth Model
per Share,
RateEstimated
Growth
RateEstimate
Value per
Share
1 $1.00 $1.20 8% 3.71% $29.036

Value per
Share
2 $2.00 $1.80 9% −2.09% $15.899
3 $0.50 $0.60 7% 3.71% $18.936
4 $0.25 $0.30 12% 3.71% $3.755
Estimating the Expected Return
Dividends
of DividendsCurrent
Value of
the StockDiscount
Rate, r
T $1.00 2% $25 6.08%
U $0.50 3% $20 5.58%
V $1.25 1% $10 13.63%
W $0.25 2% $15 3.70%
Relative Valuation
Comparable P/E MV/BV
X 15.00 1.5
Y 16.00 4
Z 12.00 1.5
Average 14.33 2.33
Company RV’s base ×$2.50 ×$20

Estimated value per share $35.83 $46.67

Valuing Common Stock 511
QUESTIONS
1.If a company maintains a constant rate of growth for the dividends per
share that it pays, what is the likely effect on the company’s dividend
payout ratio?
2.What is the relationship between the discount rate applied to a stock’s
future cash ﬂows and the value of a stock?

3.If the dividends per share of a stock are not expected to grow, whateffect does this have on the valuation of the stock?
4.Suppose the dividends of a company are $2 in one year and $3 three
years following. What is the average annual growth in dividends over
these three years?
5.In the constant growth dividend discount model, what is the relationship
between the required rate of return and the expected growth rate of
dividends?

6.If a company’s dividends are expected to decline, is it possible to stilluse the constant growth dividend discount model?
7.What is the relation between the expected return on a stock and the
stock’s dividend yield?
8.Concerning a dividend valuation model with multiple stages of growth,
a.Why would an investor use a multiphase dividend discount model?
b.In a three-phase dividend discount model, what are the three phases?

9.If the average P/E multiple for comparables is 15 and the company youwant to value has expected earnings per share of $2, what is the estimate
of this company’s price per share of stock?
10.Why might you prefer to use a measure of cash ﬂow generating ability
such as earnings instead of sales in relative valuation?

11.If an analyst expects a company’s dividend to be $2.50 next year, $3 intwo years, and then constant at $3.25 forever, what is the value of thecompany’s stock if investors require a return of 8%?
12.If investors expect a return of 12% on a stock that is expected to havea dividend yield of 4% next year, what is the expected growth rate on
this stock?
13.Explain whether you agree or disagree with the following statement:
“Unlike a dividend discount model, relative valuation seeks to explain

the factors that determine the observed value of a share of common
stock.”
14.To what extent is the procedure similar for valuation based on discount-
ing cash ﬂows and valuation by multiples?
15.In seeking to establish comparable companies in relative valuation anal-
ysis, what is the problem with specifying too stringent criteria for com-
panies to be included in the comparable group?

512

c20 JWBT310-Fabozzi July 8, 2010 13:20 Printer: Courier Westford, Westford, MA
CHAPTER20
Valuing Bonds
xInvesting in junk bonds and investing in stocks are alike in certain
ways: Both activities require us to make a price-value calculation
and also to scan hundreds of securities to ﬁnd the very few that
have attractive reward/risk ratios. But there are importantdifferences between the two disciplines as well. In stocks, we

expect every commitment to work out well because we concentrate
on conservatively ﬁnanced businesses with strong competitivestrengths, run by able and honest people. If we buy into these
companies at sensible prices, losses should be rare. ...
Purchasing junk bonds, we are dealing with enterprises that are
far more marginal. These businesses are usually overloaded withdebt and often operate in industries characterized by low returns

on capital. Additionally, the quality of management is sometimesquestionable. Management may even have interests that are
directly counter to those of debtholders. Therefore, we expect that
we will have occasional large losses in junk issues.
Berkshire Hathaway, February 21, 2003, p. 16
In this chapter we explain how to determine the price of a bond as wellas the relationship between price and yield. Then we discuss various yield

measures and their meaning for evaluating the potential performance over
some investment horizon. In particular, we explain the various conventions
for measuring the yield of a bond and why conventional yield measuresfail to identify the potential return from investing in a bond over some
investment horizon.
513

514 INVESTMENTS
VALUING A BOND
The price of any ﬁnancial instrument is equal to the present value of the
expected cash ﬂows from the ﬁnancial instrument. Therefore, determining
the price requires:
■An estimate of the expected cash ﬂows.
■An estimate of the appropriate required yield.
The expected cash ﬂows for some ﬁnancial instruments are simple to

compute; for others, the task is more difﬁcult. The required yield reﬂects the
yield for ﬁnancial instruments with comparable risk.
The ﬁrst step in determining the price of a bond is to estimate its cash
ﬂows. The cash ﬂows for a bond that the issuer cannot retire prior to its
stated maturity date (that is, an option-free bond) consists of:
■Periodic coupon interest payments to the maturity date.
■The par value at maturity.

Our illustrations of bond pricing use three assumptions to simplify the
analysis:
■The coupon payments are made every six months. (For most U.S. bond
issues, coupon interest is in fact paid semiannually.)
■The next coupon payment for the bond is received exactly six months
from now.
■The coupon interest is ﬁxed for the term of the bond.
While our focus in this chapter is on option-free bonds, later in this
chapter we explain how to value bonds with embedded options.

Consequently, the cash ﬂows for an option-free bond consist of an an-
nuity of a ﬁxed coupon interest payment paid semiannually and the maturity
value. The maturity value is the lump-sum payment that represents the re-
payment of the loaned amount, which we also refer to as the par value or
the face value of the bond. For example, a 20-year bond with a 10% coupon
rate and a par, or maturity, value of $1,000 has the following cash ﬂows
from coupon interest:

Annual coupon interest =$1,000 ×0.10=$100
Semiannual coupon interest =$100÷2=$50

Valuing Bonds 515
Therefore, there are 40 semiannual cash ﬂows of $50, and there is a
$1,000 cash ﬂow 40 six-month periods from now. Notice the treatment
of the par value. It is not treated as if it is received 20 years from now.
Instead, it is treated on a basis consistent with the coupon payments, which
are semiannual.
The required yield is determined by investigating the yields offered

on comparable bonds in the market. In this case, comparable investmentswould be option-free bonds with the same credit rating and the same ma-turity. The required yield typically is expressed as an annual interest rate.
When the cash ﬂows occur semiannually, the market convention is to use
one-half the annual interest rate as the periodic interest rate with which todiscount the cash ﬂows.
Given the cash ﬂows of a bond and the required yield, we have all

the information needed to price a bond. Because the price of a bond is the
present value of the expected cash ﬂows, it is determined by adding these
two present values:
■The present value of the semiannual coupon payments.
■The present value of the par, or maturity, value at the maturity date.
In general, we can estimate the value of a bond using the following
formula:
P=C
(1+r)1+C
(1+r)2+C
(1+r)3+···+C
(1+r)n+M
(1+r)n
or
P=(n∑
t=1C
(1+r)t)
+M
(1+r)n(20.1)
where: Pis the price in dollars.

+M
nis the number of periods until maturity, which is the number
of years ×2 for a bond that pays interest semiannually.
Cis the coupon payment in dollars per period.
ris the periodic interest rate, which for a semiannual-pay bondis the required annual yield ÷2.
Mis the maturity value.
tthe time period when the cash ﬂow is expected.
The coupon payments are equivalent to an ordinary annuity, so we can

estimate the present value of the coupon payments as an ordinary annuity.

516 INVESTMENTS
Financial calculators and spreadsheets permit us to value a bond in one
single calculation, valuing both the annuity portion (i.e., the coupon
payments) and the lump-sum payment (i.e., the maturity value) where:
The bond parameter ofIn the calculator
or spreadsheet as
Coupon payment in dollars per period C PMT
Periodic interest rate i i
Number of periods until maturity n N

Maturity value M FV
To illustrate how to compute the price of a bond, consider Bond A, a
20-year 10% coupon bond with a par value of $1,000 and interest paidsemiannually.
P=(
40∑
t=1$50
(1+0.055)t)
+$1,000
(1+0.055)40=$802.31
Let’s suppose that the required yield on this bond is 11%. The inputs for
a ﬁnancial calculation to compute the price for this bond are as follows:
C=10%×$1,000 ÷2=$50 every six months
M=$1,000
r=11%÷2=5.5% per six-month period

M=$1,000
n=20×2=40 six-month period
Suppose that instead of an 11% required yield, the required yield is 6.8%
(r=3.4%). The price of the bond would then be $1,347.04, demonstrated
as follows: The present value of the cash ﬂows using a periodic interest rate
of 3.4% (6.8%/2) is
P=(40∑
t=1$50
(1+0.034)t)
+$1,000
(1+0.034)40=$1,347.04
If the required yield is equal to the coupon rate of 10% ( r=5%), the value
of the bond would be its par value, $1,000:
P=(40∑

Valuing Bonds 517
With zero-coupon bonds , issuers do not make any periodic coupon
payments. Instead, the investor realizes interest as the difference between
the maturity value and the purchase price. The price of a zero-coupon bondis calculated by substituting zero for Cin equation (20.1):
P=M
(1+r)n(20.2)
As we state in equation (20.2), the price of a zero-coupon bond is simply

the present value of the maturity value. In the present value computation,
however, the number of periods used for discounting is not the number of
years to maturity of the bond, but rather, double the number of years. Thediscount rate is one-half the required annual yield.
1
EXAMPLE 20.1: VALUING A ZERO-COUPON BOND
Consider a zero-coupon bond that has a maturity value of $1,000,matures in ﬁve years, and has a required annual yield of 8%. What is
the price of this bond?
Solution
P=$1,000

Solution
P=$1,000
(1+0.04)10=$456.387
A fundamental property of a bond is that its price changes in the opposite
direction from the change in the required yield. The reason is that the price of
the bond is the present value of the cash ﬂows. As the required yield increases,the present value of the cash ﬂows decreases; hence, the price decreases. The
opposite is true when the required yield decreases: The present value of the

cash ﬂows increases, and, therefore, the price of the bond increases. You
can see this in Exhibit 20.1, where we show the price of Bond A for a range
of required annual yields. Bond A is a 20-year, 10% coupon bond with amaturity value of $1,000. In Exhibit 20.2 we plot the price of the same bond
for a range of annual required yields.
1This may seem counterintuitive because by deﬁnition a zero-coupon bond does
not pay interest, so a semiannual period is meaningless. However, we use the same

convention for zero-coupon bonds as coupon bonds so that the valuation and yields
are consistent between the two types of bonds.

518 INVESTMENTS
EXHIBIT 20.1 The Price-Yield Relationship for Bond A
For a bond with a $1,000 maturity value, 20 years remaining to maturity, and a
coupon (paid semiannually) of 10%:
C= $50
M= $1,000
n=4 0
and therefore:
Required Annual Yield Price
9.0% $1,092.01
9.5% $1,044.41
10.0% $1,000.00
10.5% $958.53
11.0% $919.77
11.5% $883.50
12.0% $849.54
12.5% $817.70

As you can see in Exhibit 20.2, the relationship between the value of
the bond and the yield is the bowed shape. In other words, this relationship
isconvex. The convexity of the price/yield relationship has important impli-
cations for the investment properties of a bond, as we explain later in this
chapter.
$0$500$1,000$1,500$2,000$2,500$3,000
24% 20% 16% 12% 8% 4% 0%Price of the Bond
Required Annual Yield

EXHIBIT 20.2 The Price-Yield Relationship over a Wide
Range of Required Annual Yields for Bond A

Valuing Bonds 519
TRY IT! BOND VALUES
For each of the following bonds, calculate the value of the bond. Each
bond has a maturity value of $1,000 and pays interest semiannually.
Bond Coupon RateNumber of Years
to MaturityRequired
Annual Yield
A5 % 1 0 6 %
B6 % 2 0 7 %
C5 % 1 0 4 %
D8 . 5 % 1 5 7 %
Relationship Between Coupon Rate, Yield, and Price

As yields in the marketplace change, the only variable that can change tocompensate an investor in an existing bond is the price of that bond. When
the coupon rate is equal to the required yield, the price of the bond will be
equal to its par value as we found earlier.
When yields in the marketplace rise above the coupon rate at a given

point in time, the price of the bond adjusts so that the investor can realizesome additional interest. This is accomplished by the price falling belowits par value. The capital appreciation realized by holding the bond to ma-
turity represents a form of interest income to the investor to compensate
for a coupon rate that is lower than the required yield. When a bond sellsbelow its par value, it is said to be selling at a discount. In our earlier

calculation of bond price, we saw that when the required yield is greaterthan the coupon rate, the price of the bond is always lower than the par
value ($1,000).
When the required yield in the market is below the coupon rate, the bond
must sell above its par value. This is because investors who would have theopportunity to purchase the bond at par value would be getting a coupon

rate in excess of what the market requires. As a result, investors would bidup the price of the bond because its yield is so attractive. The price would
eventually be bid up to a level where the bond offers the required yield in
the market. A bond whose price is above its par value is said to be selling atapremium.
The relationship between coupon rate, required yield, and price can be
summarized as follows:

520 INVESTMENTS
If thenand we refer to
this bond as a
Coupon rate <Required yield Price <Par discount bond
Coupon rate =Required yield Price =Par par bond
Coupon rate >Required rate Price >Par premium bond
Relationship Between a Bond’s Price and Time

If the required yield does not change between the time the bond is purchasedand the maturity date, what will happen to the price of the bond? For a bond
selling at par value, the coupon rate is equal to the required yield. As the
bond moves closer to maturity, the bond will continue to sell at par value.The price of a bond will not remain constant for a bond selling at a premium

or a discount, however. A discount bond’s price increases as it approaches
maturity, assuming the required yield does not change. For a premium bond,the opposite occurs. For both bonds, the price will equal par value at the
maturity date.
Consider Bond B, which has a par value of $1,000, a coupon rate of 5%,
and 10 years remaining to maturity. Let’s assume that the bond is currentlypriced by the market so that it has a yield of 8%, and if this yield remains

until the bond matures. As we show in Exhibit 20.3, the bond is currently
Price of the Bond
Years Remaining until Maturity
EXHIBIT 20.3 The Price-Time Relationship for a Discount
Bond: Bond B (10-Year, 5% Coupon Bond with a Par Value
of $1,000 Selling to Yield 8%)

Valuing Bonds 521
priced at $796.15. Bond B’s price increases as it approaches maturity. If the
yield is constant, this path is upward, with a slight curvature.
EXAMPLE 20.2: BOND PRICE OVER TIME
Consider a bond that has a coupon rate of 6% and is priced to yield8%. If the bond’s par value is $1,000, what is the price of the bond if
there is:
a.ﬁve years remaining to maturity?

there is:
b.10 years remaining to maturity?
c.20 years remaining to maturity?
Solution
Inputs:
C=$60/2 =$30
M=$1,000
r=8%/2 =4%
a.$918.89
b.$864.10
c.$902.07
A bond currently selling for a premium approaches its maturity value
from above. Consider Bond C, which is similar to Bond B with a 5% annual
coupon rate but is currently priced to yield 4%. In contrast to Bond B, which
is a discount bond, Bond C is a premium bond. As you can see in Exhibit

20.4, the price of this premium bond will decline over time as the bondapproaches its maturity.
Reasons for the Change in the Price of a Bond
The price of a bond will change for one or more of the following threereasons:
1.There is a change in the required yield due to changes in the creditquality of the issuer. That is, the required yield changes because the

522 INVESTMENTS
EXHIBIT 20.4 The Price-Time Relationship for a Premium
Bond: Bond C (10-Year, 5% Coupon Bond with a Par Value of
$1,000 Selling to Yield 4%)
market now compares the bond yield with yields from a different set of
bonds with the same credit risk.

2.There is a change in the price of the bond selling at a premium or adiscount without any change in the required yield, simply because thebond is moving toward maturity.
3.There is a change in the required yield due to a change in the yield oncomparable bonds. That is, market interest rates change.
Different Discount Rates Apply to Each Cash Flow So far, we’ve assumed
that it is appropriate to discount each cash ﬂow using the same discount

rate. However, we can view a bond as a package of zero-coupon bonds, in
which case a unique discount rate should be used to determine the presentvalue of each cash ﬂow. This means discounting each cash ﬂow at the spot
rate for the period when the cash ﬂow is expected to be received. That is, we
use the yield on a two-year zero-coupon bond to discount the cash ﬂow thatoccurs two years from now, we use the yield on a three-year zero-coupon

bond to discount the cash ﬂows that occurs three years from now, and
so on.
Consider Bond D that has a 5% semiannual coupon, three years re-
maining to maturity, and a par value of $1,000. And suppose we have thefollowing set of spot rates for each six-month range of maturity:

Valuing Bonds 523
Maturity Spot Rate (Annualized)
6 months 4.5%
1 year 5.0%
1.5 years 5.5%
2 years 6.0%
2.5 years 6.5%
3 years 7.0%
If we apply these rates instead of a ﬁxed discount yield, such as 6%,
we arrive at a different value for the bond, as we show in Exhibit 20.5. In

this exhibit, we show that that the price of the bond is higher using the spotrates from an upward-sloping yield curve, as compared to using the average
of the rates (i.e., 6%) or the three-year spot rate of 7%.
Price Quotes We have assumed in our illustrations that the maturity, or
par, value of a bond is $1,000. A bond may have a maturity, or par, value
greater or less than $1,000. Consequently, when quoting bond prices, traders

quote the price as a percentage of par value. A bond selling at par value is
quoted as 100, meaning 100% of its par value. A bond selling at a discountwill be selling for less than 100; a bond selling at a premium will be selling
for more than 100.
The procedure for converting a price quote to a dollar price is as follows:
(Price per $100 of par value ÷100)×Par value
For example, if a bond is quoted at 96.5 and has a par value of $100,000,
then the dollar price is
(96.5 ÷100)×$100, 000=$96,500

EXHIBIT 20.5
Valuing a Bond Using Different Spot Rates: Bond D (3-Year, 10%
Coupon Bond with a Par Value of $1,000)
PeriodCash
FlowDiscounted
at 6%Discounted
at 7%Spot Rate
(Annualized)Discounted Using
a Set of Spot Rates
6 months $25 $24.27 $24.15 4.5% $24.45
1 year 25 $23.56 $23.34 5.0% $23.80
1.5 years 25 $22.88 $22.55 5.5% $23.05
2 years 25 $22.21 $21.79 6.0% $22.21
2.5 years 25 $21.57 $21.05 6.5% $21.31
3 years 1,025 $858.42 $833.84 7.0% $833.84

Value of Bond D $972.91 $946.71 $948.65

524 INVESTMENTS
If a bond is quoted at 103.59375 and has a par value of $1 million, then
the dollar price is:
Dollar value =(103.59375 ÷100)×$1,000, 000=$1,035, 937.50
When an investor purchases a bond between coupon payments, the
investor must compensate the seller for the accrued interest.2
CONVENTIONAL YIELD MEASURES

Related to the price of a bond is its yield. We calculate the price of a bond
from the expected cash ﬂows and the required yield. We calculate the yield
of a bond from the expected cash ﬂows and the market price plus accrued
interest. In this section, we discuss various yield measures and their meaningfor evaluating the relative attractiveness of a bond.
There are three bond yield measures commonly quoted by dealers and

used by portfolio managers: (1) current yield, (2) yield to maturity, and (3)yield to call. In our illustrations below we assume that the next coupon
payment is six months from now and therefore there is no accrued interest.
Current Yield Thecurrent yield relates the annual coupon interest to the
market price. The formula for the current yield is:
Current yield =Annual dollar coupon
Price
For example, the current yield for a 15-year, 7% coupon bond with a

par value of $1,000 selling for $769.40 is 9.1%:
Current yield =$70
$769=9.1%
The current yield calculation takes into account only the coupon inter-
est and no other source of return that will affect an investor’s yield. No
consideration is given to the capital gain that the investor will realize when
2We do not delve into the nuances of valuing a bond with accrued interest. Fortu-
nately, you can use speciﬁc spreadsheet functions and ﬁnancial calculator functions

Valuing Bonds 525
a bond is purchased at a discount and held to maturity; nor is there any
recognition of the capital loss that the investor will realize if a bond pur-chased at a premium is held to maturity. The time value of money is also
ignored.
Yield to Maturity Theyield to maturity is the interest rate that will make

the present value of a bond’s remaining cash ﬂows (if held to maturity) equal
to the price (plus accrued interest, if any). Mathematically, we solve for theyield to maturity, YTM, using the same formula we used for the value of a
bond—but this time we know the value and are solving for r. For a bond
that pays interest semiannually and that has no accrued interest, we solve
forrusing:
P=(
n∑
t=1C
(1+r)t)
+M
(1+r)n
Because the cash ﬂows are every six months, the rate that we solve

for is r, which is a semiannual yield to maturity. Once we solve for r,
we need to convert this into an annual yield. We have two choices forannualizing this yield: (1) doubling the semiannual yield or (2) compounding
the yield. The market convention is to annualize the semiannual yield by
simply doubling its value. The yield to maturity computed on the basis of
this market convention of doubling the yield is the bond-equivalent yield.

We also refer to it as the yield on a bond-equivalent basis.
There is not direct solution for r, so we need to resort to an iterative
procedure. To illustrate the computation, consider Bond E, a 15-year, 7%
coupon bond with a maturity value of $1,000. Using a ﬁnancial calculatoror a spreadsheet,
PMT =$35
N=30
FV=$1,000
PV=$769.40
Solving for r, we get 5%. Therefore the yield to maturity is 5% ×2=10%.
We show the yield to maturity for different prices of Bond E in Ex-

hibit 20.6. For example, if the price of Bond E is $1,000, the yield to
maturity is the coupon rate, 7%, whereas if the price of Bond E is $1,200,
the yield to maturity is 5.1%.

526 INVESTMENTS11.2%  
10.3%
9.5%
8.8%
8.2%
7.6%
7.0%
6.5%
6.0%
5.5%
5.1%
4.7%
4.3%
0%2%4%6%8%10%12%
$700 $800 $900 $1,000 $1,100 $1,200 $1,300Yield to Maturity
Bond Price
EXHIBIT 20.6 Yield to Maturity for Different Prices of Bond E
(15-Year, 7% Coupon Bond with a Maturity Value of $1,000)
It is important to know the relation between the price and par value and

the various yield measures discussed earlier we know:
A bond selling at: therefore has:
Par Coupon rate =Current yield =Yield to maturity
Discount Coupon rate <Current yield <Yield to maturity
Premium Coupon rate >Current yield >Yield to maturity
The yield-to-maturity calculation takes into account not only the current
coupon income but also any capital gain or loss the investor will realize byholding the bond to maturity. In addition, the yield to maturity considers

the timing of the cash ﬂows. We show the relationship between the yield tomaturity and the current yield for Bond E for different prices of the bond
$700 $800 $900 $1,000 $1,100 $1,200 $1,300Yield
Value of the BondYield to maturity Current yield
EXHIBIT 20.7 Yield to Maturity and Current Yield for Different
Prices of Bond E

Valuing Bonds 527
in Exhibit 20.7. Both the yield to maturity and the current yield decline for
higher bond prices, but you can see the effects of the time value of moneyon the curvature of the yield-price relationship for the yield to maturity.
EXAMPLE 20.3: YIELDS

Consider a bond that has a coupon rate of 5%, with interest paid semi-annually, that matures in 10 years. If the current price of the bond is$975 and the maturity value of the bond is $1,000, what is the yield
to maturity and current yield on this bond?
Solution
For the yield to maturity, solve the following for rand then multiply
by 2:
$975 =(
20∑
t=1$25
(1+r)t)
+$1,000
(1+r)20
r=2.663%. Therefore the yield to maturity is 5.326%.

For the current yield, the annual coupon is $50, which we divide
by $975. Therefore, the current yield is 5.12%.
TRY IT! YIELDS
Calculate the yield to maturity and the current yield for each of the
following bonds:
BondCoupon
RateNumber of
Years to
Maturity Price
E 5.0% 5 $1,000
F 6.0% 10 $900
G 5.0% 15 $1,200
H 8.5% 20 $750

528 INVESTMENTS
Yield to Call The issuer may be entitled to call a bond prior to the stated
maturity date. When the bond may be called and at what price is speciﬁed in
the indenture. The price at which the issuer may call the bond is referred
to as is the call price. For some issues, the call price is the same regardless

of when the issue is called. For other callable issues, the call price depends
on when the issue is called. That is, there is a call schedule that speciﬁes a call
price for each call date.
For callable issues, the practice has been to calculate a yield to call as
well as a yield to maturity. The yield to call assumes that the issuer will call
the bond at some assumed call date, and the call price is then the call price

speciﬁed in the call schedule. Typically, investors calculate a yield to ﬁrst call
and a yield to par call. The yield to ﬁrst call assumes that the issue will be
called on the ﬁrst call date. The yield to ﬁrst par call assumes that the issuewill be called the ﬁrst time on the call schedule when the issuer is entitled to
call the bond at par value.
The procedure for calculating the yield to any assumed call date is the

same as for any yield calculation: Determine the interest rate that will makethe present value of the expected cash ﬂows equal to the price plus accrued
interest. In the case of yield to ﬁrst call, the expected cash ﬂows are thecoupon payments to the ﬁrst call date and the corresponding call price. For
the yield to ﬁrst par call, the expected cash ﬂows are the coupon payments
to the ﬁrst date at which the issuer may call the bond at par.
Mathematically, we can express the yield to call as:
P=⎛

P=⎛
⎝
n*∑
t=1C
(1+r)t⎞⎠+M*
(1+r)n*
where M* is the call price and n* is the number of periods to the call date. If
the coupon is paid semiannually, we ﬁrst calculate rand then multiply this
rate by 2 to arrive at the yield to call, YTC.
To illustrate the computation, consider Bond F, an 18-year, 11% coupon
bond with a maturity value of $1,000 selling for $1,168.97. Suppose that
the ﬁrst call date is 13 years from now and that the call price is $1,055. The

cash ﬂows for this bond if it is called in 13 years consist of
■26 coupon payments of $55 every six months and
■$1,055 due in 26 six-month periods from now.
We ﬁrst solve for rthat equates the current value of the bond with the
expected cash ﬂows, and then multiply this rate by 2:
$1,168.97 =(26∑
t=1$55
(1+r)t)
+$1,055
(1+r)26

Valuing Bonds 529
Using a ﬁnancial calculator or a spreadsheet, the inputs are:
PV=$1,168.97
FV=$1,055
PMT =$55
N=26
In this case, that six-month rate is 4.5%. Therefore, the yield to ﬁrst call on
a bond-equivalent basis is 9%.
Investors typically compute both the yield to call and the yield to

maturity for a callable bond selling at a premium. They then select thelower of the two as the yield measure. The lowest yield based on every
possible call date and the yield to maturity is referred to as the yield to
worst.
TRY IT! YIELD TO WORST
Estimate the yield to worst for the following callable bonds
RateCurrent
PriceNumber
of Years to
MaturityNumber
of Years to
First CallCall Price
at First
Call
1 5% $1,100 10 5 $1,000
2 6% $1,000 20 10 $1,0003 5% $1,050 5 2 $1,010

4 7% $1,100 15 5 $1,050
Potential Sources of a Bond’s Dollar Return
An investor who purchases a bond can expect to receive a dollar return from
one or more of these sources:
1.The periodic coupon interest payments made by the issuer.
2.Income from reinvestment of the periodic interest payments (the interest-
on-interest component).
3.Any capital gain (or capital loss—negative dollar return) when the bond
matures, is called, or is sold.

530 INVESTMENTS
Any measure of a bond’s potential yield should take into consideration
each of these three potential sources of return. The current yield considers
only the coupon interest payments. No consideration is given to any capital
gain (or loss) or to interest-on-interest.
The yield to maturity takes into account coupon interest and any capital

gain or loss. It also considers the interest-on-interest component; implicitin the yield-to-maturity computation, however, is the assumption that the
coupon payments can be reinvested at the computed yield to maturity. Theyield to maturity, therefore, is a promised yield; that is, it will be realized
only if (1) the bond is held to maturity and (2) the coupon interest payments

are reinvested at the yield to maturity. If either (1) or (2) does not occur, theactual yield realized by an investor can be greater than or less than the yield
to maturity when the bond is purchased.
The yield to call also takes into account all three potential sources of
return. In this case, the assumption is that the coupon payments can be
reinvested at the computed yield to call. Therefore, the yield-to-call measuresuffers from the same drawback inherent in the implicit assumption of the

reinvestment rate for the coupon interest payments. Also, it assumes that
the bond will be held until the assumed call date, at which time the bondwill be called.
The Yield to Maturity and Reinvestment Risk
The yield-to-maturity measure assumes that the reinvestment rate is the
yield to maturity. For example, let’s consider Bond G, which has ﬁve years
remaining to maturity and an 8% coupon. And let’s further assume thatBond G has a maturity value of $1,000 and a current market price of $923.

The yield to maturity for this bond is 10%.
Let’s look at the potential total dollar return from holding this bond to
maturity, which we detail in Exhibit 20.8. As mentioned earlier, the dollarreturn comes from three sources. In our example:
Cash ﬂows from interest $400
Capital gain 77
Interest on interest, from reinvesting the
interest every six months at 10% 103
Dollar return $580
The potential dollar return if the coupons can be reinvested at the yield

to maturity of 10% is then $580. In other words, the investor invests $923

Valuing Bonds 531
EXHIBIT 20.8 The Dollar Return on Bond G (5-Year, 8% Coupon,
Selling at $923)
Assuming all cash ﬂows are reinvested at 10% per year
(or 5% every six months)
Six-Month Period Cash Flow Future Value of Cash Flow
1 $40 $62.05
2 $40 $59.10
3 $40 $56.28
4 $40 $53.60
5 $40 $51.05
6 $40 $48.62
7 $40 $46.31
8 $40 $44.10
9 $40 $42.00
10 $1,040 $1,040.00
$1,400 $1,503.00

Present value of bond $923Yield 10%
and then has something worth $1,503 at the end of ﬁve years. The return
on this investment, using the inputs:
PV=$923
FV=$1,503
N=5
is 10% per year.
So an investor who invests $923 for ﬁve years at 10% per year (5%
semiannually) expects to receive at the end of ﬁve years the initial investment
plus $580. This is precisely what we found by breaking down the dollar

return on the bond, assuming a reinvestment rate equal to the yield tomaturity of 10%.
The investor will realize the yield to maturity at the time of purchase
only if the bond is held to maturity and the coupon payments can be rein-vested at the yield to maturity. The risk that the investor faces is that future
reinvestment rates will be less than the yield to maturity at the time the bond
is purchased. This risk is called reinvestment risk.

Two characteristics of a bond determine the importance of the interest-
on-interest component and, therefore, the degree of reinvestment risk: thelength of time to maturity and the coupon rate.

532 INVESTMENTS
For a given yield to maturity and a given coupon rate, the longer the
maturity, the more dependent the bond’s total dollar return is on the interest-
on-interest component in order to realize the yield to maturity at the time
of purchase. In other words, the longer the maturity, the greater the rein-

vestment risk. The implication is that the yield-to-maturity measure forlong-term coupon bonds tells little about the potential yield that an investor
may realize if the bond is held to maturity. For long-term bonds, the interest-
on-interest component may be as high as 80% of the bond’s potential totaldollar return.
Turning to the coupon rate, for a given maturity and a given yield to

maturity, the higher the coupon rate, the more dependent the bond’s totaldollar return will be on the reinvestment of the coupon payments in order
to produce the yield to maturity anticipated at the time of purchase. This
means that when maturity and yield to maturity are held constant, premium
bonds are more dependent on the interest-on-interest component than are
bonds selling at par.
Discount bonds are less dependent on the interest-on-interest component

than are bonds selling at par. For zero-coupon bonds, none of the bond’stotal dollar return is dependent on the interest-on-interest component. So azero-coupon bond has no reinvestment risk if held to maturity. Thus, the
yield earned on a zero-coupon bond held to maturity is equal to the promised
yield to maturity.
VALUING BONDS THAT HAVE EMBEDDED OPTIONS
Our approach to valuation so far has focused on option-free bonds. That

is, we’ve been dealing with bonds whose bond agreement provisions do not
grant the issuer or the bondholder the option to alter the maturity date orexchange the bond for another type of ﬁnancial instrument. Hence, assum-
ing the issuer does not default, it is rather straightforward to estimate the
cash ﬂows.
Bond valuation becomes more difﬁcult when either the issuer or bond-

holder has an option to either alter the maturity of the bond or to convertthe bond into another security. We refer to bonds that have one or moresuch options as bonds with embedded options . These bonds include callable
bonds, putable bonds, and convertible bonds.
■Acallable bond is a bond issue that grants the issuer the right to retire
(that is, call) the bond issue prior to the stated maturity date.
■Aputable bond is a bond issue that grants the bondholder the right to

have the issuer retire the bond issue prior to the stated maturity date.

Valuing Bonds 533
■In the case of a convertible bond , the bondholder has the right to convert
the bond issue into the issuer’s common stock. Moreover, all convertible
bonds are callable and some are putable.
There are sectors of the bond market that have even more complex
structures that make valuation harder because it is difﬁcult to estimate the

bond’s future cash ﬂows. For example, a major sector of the bond mar-
ket is the market for securities backed by residential mortgage loans, calledmortgage-backed securities. The cash ﬂows for these securities are monthly
and include the interest payment, the scheduled principal repayment, and
any amount in excess of the scheduled principal repayment. It is this lastcomponent of a mortgage-backed security’s cash ﬂows—the payment in ex-

cess of the regularly scheduled principal payment—that makes it difﬁcult to
project cash ﬂows. This component of the cash ﬂow is called a prepayment .
The right of homeowners whose mortgage loan is included in the pool
of loans backing the mortgage-backed security to prepay their loan at anytime in whole or in part is an option. That option is effectively equivalent
to the option in a callable bond because the borrower will ﬁnd it attractive

to make prepayments when mortgage rates in the market decline below theborrower’s loan rate.
In addition, there are securities that are backed by loans that are not
residential mortgage loans. These securities are referred to as asset-backed
securities. The structure of these securities is complex due to potential de-
faults, uncertain recovery rates, and potential prepayments, which cause

uncertainty in the amount and timing of the cash ﬂows. We won’t go intothe valuation of these securities here, but, needless to say, these valuations
are complex.
A key factor determining whether the bond issuer in the case of a callable
bond or the bondholder in the case of a putable bond would exercise anoption to alter the maturity date is the prevailing level of interest rates
relative to the bond’s coupon rate. Speciﬁcally, for a callable bond, if the

prevailing market rate that the issuer can realize by retiring the outstanding
bond issue and issuing a new bond issue is sufﬁciently below the outstandingbond issue’s coupon rate so as to justify the costs associated with refunding
the issue, the issuer is likely to call the issue. For a putable bond, if the
interest rate on comparable bonds in the market rises such that the value ofthe putable bond falls below the value at which it must be repurchased by

the issuer (i.e., the put price), then the investor will put the issue.
What this means is that to properly estimate the cash ﬂows of a bond
with an embedded option, we need to incorporate into the analysis howinterest rates can change in the future and how such changes affect the cash
ﬂows. This is done in more complicated bond valuation models. Practitioners

534 INVESTMENTS
commonly use two models in such cases: the lattice model and the Monte
Carlo simulation model. The lattice model is used to value callable bondsand putable bonds.
3The Monte Carlo simulation model is used to value
mortgage-backed securities and certain types of asset-backed securities.
The lattice model and the Monte Carlo simulation model are beyond

the scope of this book. What is important to understand is that these valua-
tion models use the principles of valuation described earlier in this chapter.
Basically, these models look at possible paths that interest rates can take inthe future and what the bond’s value would be on a given interest rate path.
A bond’s value is then an average of these possible interest rate path values.
Valuing Convertible Bonds

A convertible bond is a bond that can be converted into common stock at theoption of the bondholder. The conversion provision of a convertible bond
grants the bondholder the right to convert the bond into a predeterminednumber of shares of common stock of the issuer. A convertible bond is,
therefore, a bond with an embedded call option to buy the common stock
of the issuer.
In illustrating the calculation of the various concepts described next, we

will use a convertible bond issue of Company H, which has a coupon of 5%and matures in 30 years. For this convertible bond issue, the market price
of the bond is 80, or $800 for each $1,000 par value. Therefore, the yield
to maturity on for this bond is 6.528%.
The conversion ratio is the number of shares of common stock that

the bondholder will receive from exercising the call option of a convertiblebond. The conversion privilege may extend for all or only some portion ofthe bond’s life, and the stated conversion ratio may fall over time. For the
Company H convertible issue, suppose the conversion ratio is 150 shares.
This means that for each $1,000 of par value of this issue the bondholderexchanges for Company H common stock, 150 shares will be received.

At the time of issuance of a convertible bond, the issuer effectively grants
the bondholder the right to purchase the common stock at a price equal to:
P=Par value of the convertible bond
Conversion ratio
3The lattice model for valuing bonds with embedded options was developed in
Andrew J. Kalotay, George O. Williams, and Frank J. Fabozzi, “A Model for the
Valuation of Bonds and Embedded Options,” Financial Analysts Journal 49 (1993):
35–46.

Valuing Bonds 535
In the prospectus, this price is referred to as the stated conversion price.T h e
stated conversion price for the convertible issue of Company H per $1,000
par value is:
Stated conversion price =$1,000
150 shares=$6.67 per share
There are two approaches to valuation of convertible bonds: the tradi-

tional approach and the option-based approach. The latter approach usesthe option pricing models to value a convertible bond and will not be dis-
cussed in this chapter. The traditional approach makes no attempt to value
the option that the bondholder has been granted.
Traditional Value of Convertible Bonds Theconversion value,o r parity
value, of a convertible bond is its value if it is converted immediately. That is,
Conversion
value=Market price of
common stock×Conversion
ratio

ratio
The minimum price of a convertible bond is the greater of its:
■Conversion value, or
■Value as a bond without the conversion option—that is, based on the
convertible bond’s cash ﬂows if not converted.
This second value is the bond’s straight value orinvestment value.T o
estimate the straight value, we must determine the required yield on a non-
convertible bond with the same credit rating and similar investment char-

acteristics. Given this estimated required yield, the straight value is then
the present value of the bond’s cash ﬂows using this yield to discount the
cash ﬂows.
If the convertible bond does not sell for the greater of these two values,
arbitrage proﬁts could be realized. For example, suppose the conversionvalue is greater than the straight value, and the bond trades at its straightvalue. An investor can buy the convertible bond at the straight value and

convert it. By doing so, the investor realizes a gain equal to the difference
between the conversion value and the straight value. Suppose, instead, thestraight value is greater than the conversion value, and the bond trades at its
conversion value. By buying the convertible bond at the conversion value,
the investor will realize a higher yield than a comparable straight bond.

536 INVESTMENTS
Suppose Company H’s stock price was $5. For the convertible issue, the
conversion value per $1,000 of par value is therefore:
Conversion value =$5×150=$750
The straight value, using a discount rate of 6.53% for theoretical pur-
poses only, is $800. Because the minimum value of the Bond H convertible

issue is the greater of the conversion value and the straight value, the min-
imum value, or ﬂoor, is $800. We show this valuation graphically in Ex-
hibit 20.9. The value of the bond as a straight bond is $800 for all values of
Company H’s stock. The conversion value of the bond follows the straight
line upward, increasing as the price of the stock increases.
The price an investor effectively pays for the common stock if the

convertible bond is purchased in the market and then converted into thecommon stock is the market conversion price (also called the conversion
parity price):
Market conversion price =Market price of the convertible bond
$0$200$400$600$800$1,000$1,200$1,400$1,600
$4 $5 $6 $7 $8 $9 $10Value of the Bond
Market Value Per Share of StockConversion value of Bond H
Straight value of Bond H
Value of Bond H
EXHIBIT 20.9 Value of the Convertible Bond of Company H for Different

Valuing Bonds 537
In other words, if an investor bought Bond H for $800, he or she could
exchange it for 150 shares worth $5 ×150=$750. But the investor is
not likely to convert the bond at this stock price and would therefore hold
onto the bond that is worth $800. The market conversion price for Bond
H, assuming the market price is its straight bond at $800, is $800 ÷150=
$5.333.

$5.333.
The value of the convertible bond, which is the greater of the conversion
value or the straight value, follows the thicker line that begins at $800 andthen increases once the price of the stock is beyond the market conversion
price of $5.333, as we show in Exhibit 20.9.
The market conversion price is a useful benchmark because, once the

actual market price of the stock rises above the market conversion price, anyfurther stock price increase is certain to increase the value of the convertible
bond by at least the same percentage. Therefore, the market conversion price
can be viewed as a break-even point.
An investor who purchases a convertible bond rather than the underly-
ing stock pays a premium over the current market price of the stock. Thispremium per share, which we refer to as the market conversion premium per

share , is the difference between the market conversion price and the current
market price of the common stock. That is,
Market conversion
premium per share=Market conversion
price−Current market
price
We usually express the market conversion premium per share as a per-
centage of the current market price:
premium ratio=Market conversion premium per share
Market price of common stock
EXAMPLE 20.4: CONVERTIBLE MEASURES
FOR THE CONVERTIBLE BOND OF COMPANY H

Market conversion price =$800
150 shares=$5.333 per share
Market conversion premium per share =$5.333 −$5=$0.333
Market conversion premium ratio =$0.333
$5=6.66%

538 INVESTMENTS
Why would someone be willing to pay a premium to buy the stock?
Recall that the minimum price of a convertible bond is the greater of its con-
version value or its straight value. Thus, as the common stock price declines,
the price of the convertible bond will not fall below its straight value. The
straight value therefore acts as a ﬂoor for the convertible bond’s price.

Viewed in this context, the market conversion premium per share can
be seen as the price of a call option. The buyer of a call option—in this case,the investor in the convertible bond—limits the downside risk to the optionprice. The difference between the buyer of a call option and the buyer of a
convertible bond is that the former knows precisely the dollar amount of

the downside risk, while the latter knows only that the most that can be lostis the difference between the convertible bond’s price and the straight value.
The straight value at some future date, however, is unknown; the value will
change as interest rates in the economy change.
The investment characteristics of a convertible bond depend on the com-

mon stock price. If the price is low, so that the straight value is considerablyhigher than the conversion value, the bond will trade much like a straight
bond. The convertible bond in such instances is referred to as a ﬁxed income
equivalent or abusted convertible .
When the price of the stock is such that the conversion value is consid-
erably higher than the straight value, then the convertible bond will trade as
if it were an equity instrument; in this case, it is said to be a common stock

equivalent . In such cases, the market conversion premium per share will
be small.
Between these two cases, ﬁxed income equivalent and common stock
equivalent, the convertible bond trades as a hybrid security , having the
characteristics of both a bond and common stock.
■The value of a bond is the present value of its expected coupon paymentsand the bond’s maturity value, discounted at the bond’s required yield.

■A fundamental property of a bond is that its price changes in the opposite
direction from the change in the required yield. The value of a bond also
changes with time, approaching its maturity value as the bond matures.
■Whether a bond trades at a discount or a premium to its maturity (par)
value depends on the relationship between the coupon rate of the bond

and the yield that the market requires on the bond. When the requiredyield in the market is below the coupon rate, the bond trades above its
par value. When the required yield in the market is above the coupon
rate, the bond trades below its par value. A bond trades at its par valuewhen the coupon rate is equal to the yield required by the market.

Valuing Bonds 539
■The three bond yield measures commonly quoted in the market are the
current yield, yield to maturity, and yield to call.
■The dollar return from investing in a bond comes from one or more of
the following three sources: (1) periodic coupon interest payments, (2)

reinvestment income, and (3) any capital gain (or capital loss—negativedollar return) when the bond matures, is called, or is sold.
■A limitation of the yield-to-maturity measure is that it assumes thatreinvestment income (interest on interest) will be generated by reinvest-ing the periodic coupon income at a yield equal to the computed yield
to maturity. Reinvestment risk is the risk that coupon income will be
reinvested at a lower rate than the computed yield to maturity.

■The valuation of a bond that has an embedded option, such as a callable,
putable, or convertible bond, is more complex than an option-free bond
because the option affects the bond’s value.
■The value of a convertible bond is the greater of its straight value or itsconversion value.
Bond Values
Bond Value
A $925.61
B $893.22
C $1,081.76D $1,137.94
Yields
Bond Yield to Maturity Current Yield
E 5.00% 5.00%
F 7.44% 6.67%
G 3.30% 4.17%
H 11.78% 11.33%
Yield to Worst

Bond Yield to Maturity Yield to Call Yield to Worst
1 3.8% 2.8% 2.8%
2 6.0% 6.0% 6.0%
3 3.9% 2.9% 2.9%
4 6.0% 5.6% 5.6%

540 INVESTMENTS
QUESTIONS
1.List the four inputs needed to value a bond.
2.When valuing a zero-coupon bond, why are semiannual periods used in
discounting?
3.Describe the relationship between the price of a bond and the yield to
maturity of the bond.

4.Suppose a bond has a coupon rate of 6% and a yield to maturity of8%. Will this bond be priced as a discount bond or a premium bond?Explain.
5.Why may a bond’s price change simply because of the passage of time?
6.What is the difference between a bond’s current yield and its yield tomaturity?
7.What is the yield to worst?
8.Concerning reinvestment of interest on a bond,
a.What assumption is made about reinvestment of cash ﬂows when
using the yield to maturity?

b.What characteristics of a bond affect its reinvestment risk?
9.If a bond is putable, what type of option does the investor in this bondhave?
10.Suppose a bond has a market price of $90 and has ﬁve years remaining
to maturity. If the bond is priced to yield 5%, is its coupon rate greater
than, less than, or equal to 5%? Explain your reasoning.
11.Complete the following table, providing the dollar price of the following
bonds:
Market Price Par Value Dollar Price

bonds:
$94.0 $1,000
$102.00 $100,000
$75.50 $10,000
$86.40 $1,000,000
12.Consider a bond with coupon rate of 7% and a par value of $1,000.
The maturity for this bond is greater than one year. Also assume that
the required yield by the market for this bond is 8%. For the following
three bond prices, explain why the bond may or may not trade at therespective price.
a.$1,200
b.$1,000
c.$900

Valuing Bonds 541
13.Suppose that two years ago a 10-year bond in your portfolio was sell-
ing for $1,100. Today, the same bond is selling for $1,050. You haveresearched the price of 10-year bonds of the same credit rating over the
past two years and found that interest rates have declined. Explain why
the bond’s price declined despite the fact that 10-year interest rates havedeclined.

14.Which of the following two bonds has greater reinvestment risk: a 10-year 8% coupon bond or a 25-year zero-coupon bond? Why?
15.Why is it difﬁcult to value a callable bond?
16.If a convertible bond has a value as a straight bond of $1,100 and aconversion value of $1,050, at what price will this bond trade? Why?

542

glos JWBT310-Fabozzi July 8, 2010 13:49 Printer: Courier Westford, Westford, MA
Glossary
AA rated yield curve SeeSwap rate yield curve.
Abnormal return A return on an asset in excess of that expected for the asset’s
risk.
Absolute return Realized return on an investment.
Accelerated depreciation Depreciation in which more depreciation is deducted
early in the asset’s life, relative to straight-line depreciation.

Accounting identity The relationship among accounts such that assets are
equal to the sum of liabilities and equity.
Accounts payable Amounts due to supplies for purchases on credit.
Accounts receivable Amounts owed by customers.
Accounts receivable turnover The number of times, on average, that a credit
account is created for a customer and this account is then paid.
Accumulated comprehensive income or loss The total amount of income or

loss that arises from transactions that result in income or losses, yet are not
reported through the income statement.
Acid-test ratio SeeQuick ratio.
Active portfolio strategy A process of managing a portfolio that involves alter-
ing the portfolio to take advantage of market conditions and mispricings.
Active strategy An investment strategy that seeks to “beat the market” through
actively trading securities.
Activity ratios Ratios that provide information on the effectiveness of putting

a company’s assets to use.
Actual reserve Average amount of reserves held by a bank at the close of
business at the Federal Reserve.
Additional paid-in capital The amount paid by shareholders for stock at is-
suance in excess of par value.
Agency costs Costs that arise from conﬂicts of interest between the agent and
the principals in an agency relationship.
Agent The party who acts in the interest of the principal in an agency relation-
ship.

ship.
Alternative risk transfer A combination of an insurance contract and a capital
market instruments used to transfer risk to another party.
American option An option that can be exercised any time on or before the
expiration date.
543

544 GLOSSARY
Annual percentage return The return for a year, determined as the product of
the interest rate per compounding period and the number of compounding
periods in a year.
Annuity due An even series of cash ﬂows occurring at even intervals of time,
with cash ﬂows occurring at the beginning of each period.
APR SeeAnnual Percentage Rate.

Arithmetic rate of return The arithmetic average of subperiod rates of return.
ART SeeAlternative risk transfer.
Articles of incorporation A legal document that speciﬁes the name of the cor-
poration, its place of business, and the nature of its business.
Asset allocation The mix of investments from different asset classes in a port-
folio.
Asset management SeeInvestment management.
Asset management companies SeeInvestment company.

Asset manager SeePortfolio manager.
Asset pricing model A theoretical model of how investors price assets in the
market.
Asset retirement liability Contractual or statutory obligation to retire or de-
commission an asset.
Asset turnover SeeTotal asset turnover.
Asset-backed securities Debt obligations that are backed by assets other than
residential mortgages.
Assets Resources of a business enterprise, which may consist of cash, inven-

tory, property, and equipment.
Asymmetric information Uneven possession or access to information necessary
to value assets.
Atlantic option SeeBermuda option.
At-the-money option The situation in which a call option’s exercise price is
equal to the underlying’s value or a put option’s exercise price is equal tothe underlying’s value.
Average credit sales per day The credit sales for a period, divided by the
number of days in the period.

Average day’s cost of goods sold The cost of goods sold over a period, divided
by the number of days in the period.
Average purchases per day The purchases over a period, divided by the number
of days in the period.
Balance sheet A report of assets, liabilities, and equity of a company at a point
in time.
Balanced scorecard A set of measures of performance that address different
aspects of a company’s strategic plan.

Bankers’ acceptance Short-term loan that is backed by a bank’s promise to
pay. Generally used in import and export transactions.
Bankruptcy A legal process of settling the claims of creditors and owners for
a company in ﬁnancial distress.

Glossary 545
Bankruptcy costs The direct and indirect costs associated with a company in
Chapter 11 bankruptcy.
Base interest rate The interest rate for an investment without any default
risk, which is the sum of the real interest rate and the expected rate of
inﬂation.
Basic earnings per share Net earnings to common shareholders over a ﬁscal

period, divided by the weighted average shares outstanding during the ﬁscalperiod.
Bermuda option An option that can be exercised before the expiration date,
but only on speciﬁed dates.
Best-efforts underwriting An underwriting arrangement whereby the invest-
ment bank does not buy the issue from the issuer, but rather sells thesecurity to the public, earning a proﬁt on those shares it sells.
Beta A measure of the sensitivity of the returns on an asset to changes in the
returns in the market.

Biased expectations theory The theory that purports that forward rates repre-
sent both expected future rates, as well as other factors.
Black-Scholes option pricing model An option pricing model of a European
option, that values an option based on the price of the underlying, theexercise price, the risk free rate of interest, the time remaining to expiration,and the volatility of the underlying asset’s value.

Bond Indebtedness that has an indenture agreement. In general use, a debt
with an original maturity greater than 10 years.
Bond Indebtedness in the form of a security.
Bonding costs Costs incurred by the agent in an agency relationship to insure
that the agent acts in the principal’s best interest.
Bonus A cash reward based on some performance measure.
Book value The value of an asset at a point in time according to ﬁnancial
reporting standards.

Budget A company’s investment and ﬁnancing plans, expressed in monetary
terms.
Budgeting The mapping out of the sources and uses of funds for future periods.
Business ﬁnance SeeFinancial management.
Business risk The uncertainty associated with the sales and operating proﬁt
of a business, determined in large part by the business enterprise’s line ofbusiness.
Business risk The risk associated with the uncertainty of operating earnings;

the combination of sales and operating risk.
Busted convertible SeeFixed income equivalent.
Bylaws Rules of governance of a corporation.
Call provision A provision of a security that allows the issuer of the security
to buy the security from investors at a speciﬁed price, the call price.
Call schedule A schedule of call prices corresponding to different dates on
which a callable security can be bought back by the issuer.

546 GLOSSARY
Callable bond A debt obligation that may be bought back by the issuer at a
speciﬁed price.
Capital Long-term sources of ﬁnancing, which include interest-bearing debt
and equity.
Capital asset pricing model An asset pricing model that allows for only one
risk factor (market risk) to affect the prices of assets.

Capital budgeting The decision process of allocating a company’s funds to
long-term investments.
Capital budgeting The process of identifying and selecting investments in long-
lived assets; that is, selecting assets expected to produce beneﬁts over more
Capital lease Rental obligations that are long-term, ﬁxed obligations.
Capital market The market for long-term ﬁnancial instruments.
Capital market line The line depicting the relation between the return on a

portfolio and risk, where risk is measured in terms of the variance of thereturns of the portfolio.
Capital structure A company’s mixture of debt and equity that is used to
support the operating and investing activities of a company.
Capital structure The mix of debt and equity used to ﬁnance a company.
Capital yield The return on a share of stock from the change in the value of
the share of stock.
CAPM SeeCapital asset pricing model.
Carrying value SeeBook value.

Cash-and-carry trade A futures position in which the investor sell futures and
borrows to buy the underlying asset, and then delivers this asset and paysoff the loan at the end of the contract.
Cash conversion cycle The length of time a business enterprise ties up cash, on
average, in net working capital.
Cash ﬂow The ﬂow of funds of a company within a period of time.
Cash ﬂow from ﬁnancing activities The cash ﬂow associated with borrowing,

debt repayment, issuance of stock, the payment of dividends, and repur-chasing stock.
Cash ﬂow from investing activities The cash ﬂow associated with capital ex-
penditures, asset retirement, or other changes in long-term investments.
Cash ﬂow from operating activities The sum of net income, noncash expenses,
less any decrease in working capital accounts.
Cash ﬂow from operations SeeCash ﬂow from operating activities.
Cash ﬂow interest coverage ratio The number of times that a period’s interest

expenses could be paid by the company’s cash ﬂow before interest and taxesfor that period; a measure of a company to satisfy its debt obligations.
Cash ﬂow to capital expenditures coverage ratio The ratio of cash ﬂow of a
company over a period to the company’s capital expenditures for the period.
Cash ﬂow to debt ratio The ratio of cash ﬂow to the sum of a company’s debt
obligations.

Glossary 547
Cash market The exchange of an asset for cash.
Cash settlement contracts Futures contracts that are settled in cash, instead of
taking an offsetting position.
Cat bond SeeInsurance-linked note.
Catastrophe-linked bond SeeInsurance-linked note.
Catastrophic risk management The planning intended to minimize the impact
of potential catastrophic events.

CD SeeCertiﬁcate of deposit.
CDS SeeCredit default swap.
Certiﬁcate of deposit A promissory note of a bank to pay a depositor.
Characteristic line The empirical model such that the excess returns on a stock
are a linear function of the excess return on the market portfolio.
Classical safety-ﬁrst rules Decision rules that focus on the minimization of the
probability of loss.
Close corporation SeeClosely held corporation.

Closed-end fund A regulated investment company invests in a portfolio
of investments, but which does not issue additional shares or redeem
shares.
Closely held corporation A corporation that has a few owners who exert
complete control over the decisions of the corporation.
CML SeeCapital market line.
Cognitive biases Systematic bias in decision making.
Commercial bank Depository institution, which accepts deposits from savers

and lends or invests these deposits.
Commercial paper A promissory note issued by a large, creditworthy company
or municipality.
Commodity swap An agreement in which two parties agree to exchange pay-
ments based on the value of a speciﬁed commodity.
Common stock The security that represents the residual ownership in a cor-
poration.
Common-size analysis An analysis of the ﬁnancial accounts of a company that
requires comparing an account to a benchmark.

Comparative advantage The advantage a company has over other companies
in terms of the cost of producing or distributing goods and services.
Competitive advantage The advantage a company has over other companies
as a result of the market’s structure.
Complementary projects Projects in which the investment in one enhances the
cash ﬂows of one or more other projects.
Compound interest An arrangement in which interest is paid on both the

principal amount and the accumulated interest.
Compounding The process of interest being paid on both the principal and the
interest already earned on this principal.
Conditional value at risk A safety-ﬁrst rule that focuses on expected value of
a portfolio’s returns, given that the value at risk has been exceeded.

548 GLOSSARY
Contingent projects Projects that are dependent on the acceptance of another
project.
Continuous compounding Interest that is compounded instantaneously.
Contracting costs The costs associated with creating and enforcing contractual
agreements, such as a loan.
Conversion parity price SeeMarket conversion price.

Conversion provision A provision of a security that allows the investor to
exchange the security for another security.
Conversion ratio The number of shares of common stock that the investor in
a convertible security receives if the investor chooses to convert the security
into stock.
Conversion value The value of the stock that an investor in a convertible re-
ceives in exchange for the convertible security; the product of the conversionratio and the market price of the stock.

Convertible bond An indebtedness that may be converted into ownership units
of the issuer at the option of the investor at a speciﬁed rate.
Convertible bond A debt obligation that permits the investor to exchange the
bond for another security, such as the common stock of the bond issuer.
Convertible note SeeConvertible bond.
Core risk Risks that a business enterprise is in the business to bear.
Corporate ﬁnance SeeFinancial management.

Corporation An entity granted its existence by a state, operated to the beneﬁt
of the owners (the shareholders), who have limited liability.
Correlation A standardized measure of how the outcomes of two assets co-
vary, which ranges from –1 to +1; the result of the covariance of two
assets’ possible outcomes divided by the product of the two assets’ standarddeviations.
Cost of capital The return that providers of capital (creditors and owners)

expect for the use of their funds; the marginal cost of raising an additionaldollar of capital.
Counterparty The other party to an exchange.
Counterparty The party on the opposite side of the transaction.
Counterparty risk The uncertainty regarding the ability of the counterparty to
perform in a transaction.
Covariance of a random variable A measure of how two assets’ returns vary
together for a given probability distribution.

Credit default swap An agreement for credit protection against speciﬁed events
that affect the credit quality of a bond.
Credit protection buyer The party to a credit default swap that pays for pro-
tection from speciﬁc events that affect the credit quality of a security.
Credit protection seller The party to a credit default swap that agrees to insure
against the impairment of the credit quality of a security.

Glossary 549
Credit spread The risk premium between the yields on Treasury securities and
non–Treasury securities.
Creditor The lender of funds.
Crossover rate The discount rate at which the net present values of two projects
are equal.
Currency swap An agreement in which two parties agree to swap cash ﬂows
in different currencies.

Current assets Assets that can reasonably be converted into cash within one
operating cycle or one year, whichever is longer.
Current liability An obligation that is due within one year or one operating
cycle, whichever is longer.
Current ratio A liquidity ratio that measures the company’s ability to meets
its current obligations, calculated as is the ratio of current assets divided by
current liabilities.

Current yield The ratio of the annual coupon on a bond to its market value.
CVaR SeeConditional value at risk.
Date of record The date that determines which investors receive a particular
distribution.
Days purchases outstanding On average, the number of days of purchases
outstanding at the end of the period.
Days sales in inventory The number days of inventory on hand at a point in
time, considering the average days’ sales.

Days sales outstanding The number of days of credit sales that are represented
by the account balance in accounts receivable.
DDM SeeDividend discount models
Debt A promise to repay the amount borrowed, plus interest, at a speciﬁed
point of time in the future.
Debt instrument SeeDebt.
Debt ratio The ratio of debt to equity.
Debt-equity ratio SeeDebt-to-equity ratio.
Debt-to-assets ratio The proportion of the assets of a company that are ﬁ-

nanced by debt obligations; the ratio of debt to total assets.
Debt-to-capital ratio The ratio of interest-bearing debt to total capital.
Debt-to-equity ratio The ratio of debt to equity of a company.
Declaration date The date the board of directors declares a distribution.
Declining balance method Depreciation method in which a constant rate is
applied against a declining carrying value of an asset.
Default risk The risk that the issuer of a security will be unable to make timely

payment of interest or principal when due.
Deferred annuity An even series of cash ﬂows occurring at even intervals of
time, with the ﬁrst cash ﬂow occurring beyond one period from today.
Deferred tax liability An account that represents the expected tax obligation.

550 GLOSSARY
Deﬁned beneﬁt plan A pension plan in which the plan sponsor promised to
make speciﬁed payments to qualifying employees at retirement.
Deﬁned contribution plan A pension plan in which the plan sponsor commits
to a speciﬁed contribution, but the amount upon retirement is not guaran-
teed.
Degree of ﬁnancial leverage A measure of the sensitivity of earnings to owners

to changes in operating earnings, attributed to the use of debt ﬁnancing.
Delivery date SeeSettlement date
Demand deposit Funds deposited with a bank that can be withdrawn upon
demand of the depositor.
Depository institutions An entity that accepts deposits and loans funds.
Depreciation tax shield The amount of the reduction in taxes resulting from
the depreciation deduction.
Derivative A security whose value depends on the value of an underlying asset,
such as a stock.

Derivative instrument SeeDerivative.
DFL SeeDegree of ﬁnancial leverage.
Diluted earnings per share Adjusted net earnings to common shareholders
over a ﬁscal period, divided by the weighted average shares potentially out-standing during the ﬁscal period, where potential shares reﬂect convertiblesecurities and executive stock options.
Discount rate The rate of interest that Federal Reserve Bank charges banks
who borrow using the Fed discount window.

Discount rate Rate of interest used to translate future cash ﬂows into a value
today.
Discounted payback period The time it takes for a project’s discounted cash
inﬂows to add up to the initial cash outﬂow.
Discounting The process of determining a present value of some future value
or set of cash ﬂows.
Diversiﬁable risk factors SeeUnsystematic risk factors.
Diversiﬁcation The reduction of risk from investing in assets whose returns

are not perfectly correlated with one another.
Diversiﬁcation The reduction of risk, without sacriﬁcing return, by investing
in assets whose returns are not perfectly, positively correlated.
Diversify The application of diversiﬁcation principles to reduce the risk of a
Dividend A distribution to share owners.
Dividend A distribution to the owners of a corporation.
Dividend discount models Models for valuing stock that uses an estimate of

current dividends, expected growth in dividends, and a required rate ofreturn.
Dividend payout ratio The proportion of earnings paid in the form of cash
dividends during a period.

Glossary 551
Dividend payout ratio The proportion of earnings paid out in the form of cash
dividends to shareholders.
Dividend per share The monetary amount of dividend paid per share of
stock.
Dividend reinvestment plan A program that allows shareholders to reinvest
cash dividends in shares of the company.
Dividend yield The return on a share of stock in the form of dividends; the

ratio of dividend per share to the share price.
Dividend yield The ratio of dividends on a share of stock to the market value
of the stock.
Dividend–price ratio SeeDividend yield.
Dividends per share A monetary amount of dividends that are paid per share
of stock.
Dividends received deduction A deduction available to corporations of a por-
tion of the dividends received from another corporation.
Dollar return The sum of the change in the market value of a portfolio and

any capital or income distributions from the portfolio.
Dollar-weighted rate of return The internal rate of return of an investment.
Domestic market Market in which issuers domiciled in a country issue securi-
ties and in which these securities are traded.
Downside risk SeeLower partial moment risk measure.
DPO SeeDays payables outstanding.
DRP SeeDividend reinvestment plan.
DSI SeeDays sales in inventory.
DSO SeeDays sales outstanding.

DuPont system A method of decomposing a return ratio into its components,
such as proﬁt margins and turnovers, to facilitate understanding of change
in the return ratio.
Dutch auction An offer to buy that speciﬁes a range of prices, with those
willing to sell specifying a price within the range. Once offers are made,the buyer pays that price (based on bids) necessary to purchase the desiredquantity.

Dynamic asset allocation An process of altering the mix of assets in a port-
folio from the portfolio’s long-term mix in response to changing marketconditions.
EAR SeeEffective annual rate.
Earnings before interest, depreciation, and amortization Operating income of
a company before the deduction for depreciation expense and amortization.
EBITDA SeeEarnings before interest, depreciation, and amortization.
Economic agents Entities that make investment decisions in ﬁnancial markets.

Economic life The length of time that the investment provides economic
proﬁts.
Economic value added A measure of a company’s economic proﬁt.

552 GLOSSARY
Effective annual rate The rate of interest for an annual period that takes into
account the compounding of interest within the year.
Effective rate of interest SeeEffective annual rate.
Efﬁcient frontier The set of efﬁcient portfolios for a set of assets.
Efﬁcient portfolio A portfolio that provides the highest expected return for a
given level of risk.

Employee stock ownership plan A deﬁned contribution pension plan that is
designed to invest in the employer stock on the behalf of the employee.
Enterprise risk management The management of the risk of a business enter-
prise that is inclusive of the different operations, segments, and subsidiaries
of a business entity, which views risk of the entire enterprise.
Equity The ownership interest in a business enterprise.

Equity instrument A security or unit of ownership in a company.
Equity investment style A process of classifying equity securities based on a
dimension or characteristic, such as size or a multiple, with expectation oftaking advantage of superior returns that are attributed to the dimension orcharacteristic.
Equivalent taxable yield The yield on a taxable security that is equivalent, after
tax, to the return on a similar maturity, features, and risk to a municipal,nontaxable security.

ERM SeeEnterprise risk management.
ESOP SeeEmployee stock ownership plan.
ETF SeeExchange-traded fund.
Euromarket SeeExternal market.
European option An option that can only be exercised at the end of the expi-
ration period.
EVA SeeEconomic value added.
Excess reserve The amount by which actual reserves exceed required reserves
of a bank.
Exchange A market with a physical location for the trading of assets.
Exchange-traded fund A fund, similar to an open-end fund or a closed-end

fund, with units representing shares of this fund traded much like stocks.
Ex-date Seeex-dividend date.
Ex-dividend date The date determined by the exchanges to identify which
investors are owners as of the declared date of record.
Exercise price SeeStrike price.
Expansion project A project that enlarges the company’s established market
or product line.
Expectations theory A theory that states that the observed structure of interest

rates reﬂects investors’ expectations regarding future interest rates.
Expected shortfall SeeConditional value at risk.
Expected tail loss SeeConditional value at risk.

Glossary 553
Expense ratio An annual operating expense associated with a regulated invest-
ment company.
External market A market in which securities are offered at issuance simul-
taneously to investors in a number of countries and issued outside the
jurisdiction of any single country.
Face value SeeMaturity value.

Feasible portfolio Any portfolio that can be constructed with available assets.
Fed discount window The lending of funds to banks by the Federal Reserve to
meet banks liquidity needs.
Federal funds market The market that banks use to manage any shortage in
the required reserve.
Federal funds rate The rate of interest charged to banks on borrowed funds.
Fiduciary duty The legal responsibility to make decisions or to see that deci-

sions are made that are in the best interest of a party.
FIFO SeeFirst-in, First-out.
Finance The application of economic principles to decision making that in-
volves the allocation of money under conditions of uncertainty.
Financial analysis The analysis of the ﬁnancial performance and ﬁnancial con-
dition of a company.
Financial asset Intangible asset that represents a claim on future cash ﬂows.
Financial distress Situation in which a company makes decisions under pres-

sure to satisfy its legal obligations to creditors.
Financial economics Another term used to identify ﬁnance, which emphasizes
the role of economics in ﬁnancial decision making.
Financial instrument Evidence of ownership to a claim on future cash ﬂows,
such as a stock or a bond.
Financial intermediary An entity that facilitates the ﬂow of funds from those
with excess funds to those in need of funds for investment purposes.
Financial leverage The use of debt to ﬁnance a business enterprise.

Financial management The ﬁnancial decision making of a business entity. Also
referred to as business ﬁnance and corporate ﬁnance.
Financial planning The allocation of a company’s ﬁnancial resources to achieve
a company’s investment objectives.
Financial restructuring A signiﬁcant alteration of a company’s capital struc-
ture.
Financial risk Uncertainty associated with a party’s reliance on debt ﬁnancing,
relative to equity ﬁnancing.

Financial risk The uncertainty associated with the earnings to the owners of a
business due to the use of debt, which generally has a ﬁxed cost and commitsthe business to a legal obligation to repay the debt.
Financial risk The uncertainty regarding the outcome in terms of a ﬁnancial
measure, such as earnings.

554 GLOSSARY
Finite life general DDM A speciﬁc dividend discount model that uses a terminal
or expected future price of the stock at some future period in place of a set
of dividends beyond that point in time.
Firm commitment offering An underwriting arrangement whereby the invest-
ment bank buys the securities from the issuer and then sells these securitiesto investors.

First-in, ﬁrst-out Inventory method in which the oldest costs of inventory are
used in calculating costs of goods sold.
Fixed asset A long-term asset that has a physical existence, such as equipment
or a building.
Fixed income equivalent The value of a convertible security as a straight bond,
which results from the value in conversion being signiﬁcantly below thesecurity’s straight value.
Fixed income instrument Financial assets whose cash ﬂows are speciﬁed con-

tractually, such as a bond or a note.
Flat yield curve A yield curve in which the rates of higher- and shorter-maturity
securities are similar.
Foreign market Market in which issuers not domiciled in a country issue se-
curities and the securities are traded.
Foreign market The market for securities that are issued by issuers who are
not domiciled in the country.
Forward rate The interest rate that is expected to exist in the future.
Forward stock split SeeStock split.

Framing Decision making that is inﬂuenced by the situation or the manner in
which the situation is presented.
Free cash ﬂow The cash ﬂow of a company in excess of the expenditures for
proﬁtable investments.
Free cash ﬂow to equity Cash ﬂow from operations, less capital expenditures,
plus net borrowings.
Free cash ﬂow to the ﬁrm Cash ﬂow from operations, adjusted for the after-tax
interest expense, less capital expenditures.

Funded retained risk An assumed risk in which funds are set aside to absorb
potential losses.
Futures contract A legal agreement between a buyer and seller such that the
seller agrees to make a delivery and the buyer agrees to take delivery ofsomething at a speciﬁed price at the end of a speciﬁed period of time.
Futures price The price agreed to in a futures contract for a speciﬁc transaction.
GAAP SeeGenerally accepted accounting principles.

General partnership A partnership in which the partners share in the manage-
ment of the business, share in its proﬁts and losses, and are responsible forthe liabilities of the business.
Generally accepted accounting principles In the United States, accounting
methods that are codiﬁed by the Financial Accounting Standards Board.

Glossary 555
Government-owned corporation Corporate entities funded by the federal gov-
ernment for speciﬁc projects.
Government-sponsored enterprise A corporations created by the federal gov-
ernment.
Gross plant and equipment The total cost of physical assets.
Gross proﬁt margin The ratio of gross proﬁt to revenues.
Gross property, plant, and equipment SeeGross plant and equipment .

Growth rate The rate at which a value appreciates or depreciates.
GSE SeeGovernment-sponsored enterprise.
Hedge fund A pool of investment funds that are not regulated and are available
for investment only to accredited investors.
Hedgeable rate SeeForward rate.
Heuristic A rule of thumb or guide that reduces decision time.
Holding period return The yield on an asset over a speciﬁed period, considering
the change in the value of the asset and any cash ﬂows, such as interest or
dividends.

Horizontal common-size analysis The restatement and comparison of accounts
relative to a benchmark, where that benchmark is that accounts value in aselected base year.
Humped yield curve A yield curve in which the rates of longer-maturity se-
curities are similar to those of shorter-maturity securities, but less than therates on intermediate-maturity securities.
Illegal insider trading The trading of the stock of a company based on non-

public, material information by an insider of the company.
Income statement A summary of operating performance of a business entity
over a period of time.
Incremental cash ﬂows The change in a company’s cash ﬂows related to a
speciﬁc project.
Independent directors SeeOutside directors.
Independent projects Projects whose cash ﬂow are not related to those of
another project.
Indexed funds A regulated investment company that invests funds in a portfo-
lio that is intended to replicate an index.

Individually managed account SeeSeparately managed account.
Individually sponsored plan A pension plan that is for a speciﬁc individual.
Information asymmetry The situation in which a party or parties to a transac-
tion have more information than the other party or parties to the transac-tion.
Initial margin The minimum amount deposited per contract at the inception
of a position.

Inside directors Members of the board of directors who are employees of the
corporation.
Insurance premium The payment made for insurance protection.

556 GLOSSARY
Insurance-linked note Synthetically insurance in the form of a capital market
debt obligation, often used for insurance large losses, such as catastrophe
losses.
Intangible asset An asset that has no physical existence.
Intangible asset A nonﬁnancial asset that does not have a physical existence,
but creates future cash ﬂows for a company.

Interbank yield curve SeeSwap rate yield curve.
Interest coverage ratio The number of times that a period’s interest expenses
could be paid by the company’s earnings before interest and taxes for thatperiod; a measure of a company to satisfy its debt obligations.
Interest rate swap An agreement in which two parties agree to swap cash ﬂows
based on interest rates.
Interest tax shield The amount of tax savings due to the deductibility of interest

to arrive at taxable income, computed as the product of the marginal taxrate and the interest expense.
Internal market The domestic and foreign markets for securities issued in the
domestic market.
Internal rate of return The yield on an investment, assuming that all interme-
diate cash ﬂows are reinvested at this yield; the discount rate at which thepresent value of all cash ﬂows of an investment is equal to zero.
In-the-money option The situation in which a call option’s exercise price is

less than the underlying’s value or a put option’s exercise price is greaterthan the underlying’s value.
Intrinsic value The value of an option if exercised immediately.
Inventories Investments in raw material, work in process, and ﬁnished goods,
which are expected to be sold to customers.
Inventory turnover The number of times, on average, that inventory ﬂows into
and out of a company.
Inverted yield curve A yield curve in which the rates of longer-maturity secu-

rities are lower than those of shorter-maturity securities.
Investment company An entity that manage the funds of individuals, busi-
nesses, and state and local governments.
Investment management The decision making regarding individual and institu-
tional funds. Also referred to as asset management, portfolio management,money management, and wealth management.
Investment manager SeePortfolio manager.
Investment proﬁle An graph of a capital project’s net present value as a func-

tion of its cost of capital.
Investment value SeeStraight value.
Investor A party that buys an asset, such as a security, with the anticipation
of a return in the form of future cash ﬂows.
Investor’s equity The value of an investment position reduced by any borrowed
amount.

Glossary 557
IRR SeeInternal rate of return.
Issuer An entity that provides a security, such as a stock or a bond, in exchange
for funds.
Joint venture A business entity formed as either a corporation or a partnership,
generally for a speciﬁc business purpose and life.
Key performance indicators Measures used in a balanced scorecard.

Last-in, ﬁrst-out Inventory method in which the most recent costs of inventory
are used in calculating costs of goods sold.
Leveraged portfolio A portfolio in which the investor borrows funds to pur-
chase some of the assets in the portfolio.
Liabilities Obligations to repay the amount owed, in some cases with interest.
LIBOR SeeLondon Interbank Offered Rate.
LIFO SeeLast-in, First-out.
Limited liability The presence of a limit on owners’ liability for obligations of
the business enterprise.

Limited liability company A form of business in which the owners have limited
liability, but the business may elect to be taxed as a partnership.
Limited liability partnership A form of business in which the owners have
limited liability.
Limited partnership A partnership that has at least one general partner and
one limited partner, where the business is conducted by the general partner

and the limited partner or partners have a limited interest in the proﬁts andlosses of the business.
Liquidity In the context of a market, the presence of buyers and sellers ready
to trade. In the context of a business enterprise, the ability of a businessenterprise to satisfy its short-term obligations.
Liquidity premium The additional compensation for the risk associated with
being able to sell a security for close to its true value.

Liquidity risk The risk associated with the ability to sell a security at a value
close to its true value.
Liquidity theory The theory that purports that the higher rates for longer-
maturity securities in an upward-sloping yield curve represents compensa-tion for liquidity and, therefore, the forward rates derived from the yieldcurve are not unbiased estimates of future interest rates.
Listed The situation in which an issuer of securities has selected to have its

securities traded in the market.
LLC SeeLimited liability company.
LLP SeeLimited liability partnership.
Loan amortization An arrangement in which the principal amount of a loan is
paid off over time, with more principal repaid in each successive payment.
London Interbank Offered Rate The rate major international banks are willing
to offer on Eurodollar deposits to each other.
Long call position An investment position that involves buying call options.

558 GLOSSARY
Long futures SeeLong position in futures.
Long position in futures The investment position in which the investor buys a
futures contract.
Long put position An investment position that involves buying put options.
Long-run planning SeeLong-term planning.
Long-term liability Obligations due beyond one year.

Long-term planning Financial planning for future periods, usually three to ﬁve
years in the future.
Lower partial moment risk measure A safety-ﬁrst rule that uses both the in-
vestor’s risk aversion and a target rate of return.
MACRS SeeModiﬁed Cost Recovery System.
MAD SeeMean-absolute deviation.
Maintenance margin The minimum level that an investor’s equity may fall
from adverse price movements before the investor is required to deposit
additional funds.

Mandated project A project that is required by an outside party, such as a
government agency.
Marginal tax rate The tax rate on the next dollar of taxable income.
Market anomaly A strategy that can generate abnormal returns.
Market cap SeeMarket capitalization.
Market capitalization The total value of stock outstanding, which is calculated
as the product of the market price per share and the number of sharesoutstanding.

Market conversion premium per share The difference between the market
conversion price for a convertible security and the current market price ofthe stock that can be obtained through conversion.
Market conversion premium ratio The market conversion premium, stated as
a percentage of the market value of the stock for which a convertible securitycan be exchanged.
Market conversion price The effective value per share of stock in conversion

of a convertible security; the ratio of the market price of a convertible bondto the conversion ratio.
Market risk The risk related to the overall movement of the market.
Market segmentation theory The theory that purports that the shape of the
yield curve is due to preferred maturities of investors.
Market structure The mechanism in which buyers and sellers interact to de-
termine the price and quantity in an exchange.
Market value added A measure of the difference between the market value of

capital and the amount of invested capital.
Marketable securities Securities that can be some quickly.
Markowitz diversiﬁcation SeeDiversiﬁcation.
Master limited partnership A limited partnership with limited partner interests
traded on a public exchange.

Glossary 559
Maturity intermediation The transformation of longer-term assets into
shorter-term assets.
Maturity spread The spread between any two maturities in a sector of a
market.
Maturity value The amount of a loan due at the end of the loan period.
Mean-absolute deviation A measure of dispersion that is based on the absolute
value of deviations from the mean.

Mean-standard deviation SeeStandard deviation.
Mean-variance analysis SeeMean-variance portfolio analysis.
Mean-variance efﬁcient portfolio SeeEfﬁcient portfolio.
Mean-variance portfolio analysis The theory proposed by Harry Markowitz
that focuses on assets’ mean and variance as criteria for portfolio
selection.
Merchant banking An investment bank that commits its own capital in lending
or taking an equity stake in a business entity.

Minority interest In a balance sheet, the proportion of a company’s assets not
owned by the parent company. In an income statement, the earnings of acompany representing the interest not owned by the parent company.
MLP SeeMaster limited partnership.
Modern portfolio theory The theory developed by Harry Markowitz that fo-
cuses on the role of diversiﬁcation within a portfolio in affecting the riskand return of a portfolio of invested assets.

Modiﬁed Accelerated Cost Recovery System A depreciation system used for
U.S. taxes that is based on an accelerated method of depreciation.
Modiﬁed Cost Recovery System A system of depreciation prescribed by the
U.S. Tax Code.
Modiﬁed internal rate of return The return on an investment, considering a
speciﬁc reinvestment rate.
Money management SeeInvestment management.
Money management SeePortfolio management.
Money manager SeePortfolio manager.
Money market The market for short-term securities.

Money market demand account An account in which funds are deposited and
earn interest, though restrictions may be placed on withdrawals.
Money-weighted rate of return SeeDollar-weighted rate of return.
Monitoring costs Costs associated with monitoring or limiting the actions of
an agent in an agency relationship.
Mortgage-backed securities Securities that are backed, or secured with mort-
gages.
MPT SeeModern portfolio theory.

gages.
Municipal yield ratio The ratio of the municipal bond yield to a comparable-
maturity Treasury security.
Muni-Treasury yield ratio SeeMunicipal yield ratio

560 GLOSSARY
Mutual fund A regulated investment company that solicits funds from in-
vestors and then invests these funds in a portfolio of investments, with the
opportunity for investors to redeem shares and to invest additional funds.
Mutually exclusive projects Projects for which the acceptance of one precludes
the acceptance of the other(s).
MVA SeeMarket value added.

National market SeeInternal market.
NCF SeeNet cash ﬂow.
Nearby futures contract The futures contract with the closest settlement date
to the particular contract.
Negotiable CD SeeNegotiable certiﬁcate of deposit.
Negotiable certiﬁcate of deposit A promissory note of a bank that can be
bought and sold by investors.
Net cash ﬂow The sum of operating and investment cash ﬂows in a given
period of an investment’s economic life.

Net operating cycle SeeCash conversion cycle.
Net plant and equipment Cost of physical assets, less accumulated deprecia-
tion.
Net present value The value today of all cash ﬂows of a project, discounted at
the project’s cost of capital.
Net present value proﬁle SeeInvestment proﬁle.
Net proﬁt margin The ratio of net income to revenues.
Net property, plant, and equipment SeeNet plant and equipment.

Net working capital The short-term assets that would remain if current liabili-
ties are satisﬁed; the difference between current assets and current liabilities.
Net working capital to sales ratio The current assets available, after meeting
current obligations, per dollar of sales.
Next futures contract The futures contract with a settlement date just after a
particular contract’s settlement date.
Noncore risk Risks that are incidental to the operations of a business.

Nondiversiﬁable risk factors SeeSystematic risk factors.
Nonlinear payoff A payoff on an investment such that the downside risk is
different than the upside potential.
Nonsystematic risk The risk that can be diversiﬁed away.
Note Indebtedness that does not have an indenture agreement. In general use,
a debt with an original maturity less than or equal to 10 years.
Notes payable Indebtedness in the ﬁrm of a security.
Notional amount SeeNotional principal amount.

Notional principal amount Principal amount that serves as the basis for the
determination of cash ﬂows in a swap agreement.
NPV SeeNet present value.
Number of days of credit SeeDays sales outstanding.
Number of days of inventory SeeDays sales in inventory.

Glossary 561
Number of days of purchases SeeDays payables outstanding.
OCF SeeOperating cash ﬂows.
Offshore market SeeExternal market.
Open interest The number of contracts entered into but not yet liquidated.
Open-end fund SeeMutual fund.
Operating cash ﬂows The cash ﬂows related to the revenues, expenses, and
depreciation of assets involved in a capital project.

Operating cycle The length of time it takes to turn the investment of cash into
goods and services for sale back into cash in the form of collections from
Operating proﬁt margin The ratio of operating proﬁt to revenues.
Operating risk The degree of uncertainty concerning operating cash ﬂows that
arises from the particular mix of ﬁxed and variable operating costs.
Operational budgeting Short-term ﬁnancial planning.

Optimal capital structure The mix of debt and equity ﬁnancing the company
that maximizes the value of the company.
Optimal portfolio The best portfolio of the set of portfolios on the efﬁcient
frontier; the point of tangency of the efﬁcient frontier and an investor’sutility curve.
Option premium The cost of an option.
Option price SeeOption premium.
Option writer The seller of an option.
Order-driven market structure A market in which centralized bid-matching

matches the orders of the buyers and sellers.
Ordinary annuity An even series of cash ﬂows occurring at even intervals of
time, with cash ﬂows occurring at the end of each period.
OTC SeeOver-the-counter market.
Out-of-the-money option The situation in which a call option’s exercise price
is greater than the underlying’s value or a put option’s exercise price is lessthan the underlying’s value.
Outside directors Members of the board of directors who are not employees
of the corporation.

Over-the-counter market A market that does not have a physical existence,
but which trades securities or other assets through a network of dealers.
Owners’ equity SeeEquity.
Par value A stated amount of a security. In the case of a bond, the par value is
the bond’s maturity value.
Parity value SeeConversion value.
Partnership A business owned by more than one party.
Partnership share Ownership unit in a partnership.
Passive funds SeeIndexed funds.

Passive portfolio strategy A process of managing a portfolio that is focused on
the construction of a portfolio that is consistent with the portfolio objectives,

562 GLOSSARY
but without signiﬁcant management of investments after the construction
of the portfolio.
Passive strategy An investment strategy that does not involve active manage-
ment of a portfolio, and involves minimal trading of securities in the port-folio.
Payback period The time it takes for the cash inﬂows from a project to add up
to the initial cash outﬂow.

Payment date The date, determined by the board of directors, on which a
dividend distribution is made.
Performance evaluation The measurement of the return on a portfolio, con-
sidering the portfolio’s benchmark’s return and the portfolio’s risk.
Performance shares Share of stock given to employees, based on some measure
of operating performance.
Perpetuity A uniform series of cash ﬂows occurring at even intervals of time
forever.
PISeeProﬁtability index.

forever.
Plan sponsor An entity that establishes a pension plan, such as a business or a
union.
Plowback ratio SeeRetention ratio.
Policy asset allocation The long-term asset mix of a portfolio.
Porter’s Five Forces Forces that affect the ability of companies in an industry to
generate economic proﬁts: bargaining power of suppliers, bargaining powerof buyers, threat of new entrants, threat of substitute products, and rivalry.

Portfolio Set of investments that are managed for the beneﬁt of the client or
clients.
Portfolio management The process of managing investments.
Portfolio manager The person who manages a portfolio by selecting invest-
ments, monitoring the portfolio’s performance, and measuring and evalu-ating the portfolio’s performance.
Positively sloped yield curve SeeUpward-sloping yield curve.
Postpayback duration The economic life of a project beyond its payback pe-
riod.

riod.
Preferred habitat theory The theory that purports that yields in a yield curve
represent both future interest rates, but also a premium for risk.
Preferred stock An ownership interest in a corporation that has a supe-
rior claim to the income and assets of a company relative to commonstock owners, which may have a ﬁxed maturity or may be a perpetualsecurity.
Premium In the context of insurance, the amount paid to receive protection
against an occurrence of an event.

Prepayment The option that a borrower has to prepay a portion or all of the
loan prior to maturity.
Price discovery The process of determining a price of an asset by the interac-
tions of buyers and sellers.

Glossary 563
Price efﬁciency A characteristic of markets which describes asset prices as
reﬂecting available information, such that it is not possible to earn returns
in excess of that considering the asset’s future cash ﬂows and risk.
Primary market The market in which an issuer ﬁrst issues a security to investor,
receiving funds in exchange for the security.

Principal The person or group of persons the agent represents in an agency
relationship.
Private plan A pension plan sponsored by a business entity for its employees.
Pro forma balance sheet A projected balance sheet, which summarizes expected
amounts of assets, liabilities, and equity.
Pro forma income statement A projected income statement which summarizes
expected income and expenses.

Probability distribution A set of probabilities for each possible outcome for a
random variable.
Professional corporation A form of business in which owners have unlimited
liability, but which is treated as a partnership for tax purposes.
Proﬁtability index The ratio of the present value of the cash inﬂows to the
present value of cash outﬂows of a project.
Proﬁtability ratios Ratios that provide information on what is left of revenues
after expenses.

Prospect theory A theory of decision making under uncertainty, describing
behavior as involving a heuristic: ﬁrst, individuals consider the possible in-vestments and decide which ones are similar and which ones are different;second, the individuals then evaluate the possible outcomes and probabili-ties, selecting the investment that has the highest utility.
Public corporation SeePublicly held corporation.

Publicly held corporation A corporation with ownership interests sold outside
of a close group.
Pure expectations theory The theory that purports that forward rates are ex-
pected future interest rates.
Put provision A provision of a security that allows the investor to sell the
security back to the issuer at a speciﬁed price.
Putable bond A debt obligation that may be sold back to the issuer at a speciﬁed
price.

price.
Quick ratio A liquidity ratio that measures the company’s ability to meet its
current obligations, calculated as the ratio of current assets, less inventory,divided by current liabilities.
Quote-driven market structure A market in which intermediaries, such as mar-
ket makers, provide quotes for purchase and sales, and stand ready to buyor sell at these quotes.
Rate of return The dollar return on an investment, expressed as a percentage
of the initial investment.

Rating agencies Companies that evaluate and rate the default risk of debt

564 GLOSSARY
Real interest rate The rate of interest that would exist in the economy in the
Record date SeeDate of record.
Regression analysis The application of statistical techniques to gauge the rela-
tion between two of more variables.
Regression line A statistical depiction of the average relationship between two
(or more) variables.

Regulated investment company A ﬁnancial intermediary that sells shares to
the public and invests those proceeds in a diversiﬁed portfolio of securities.
Reinvestment risk The risk that the investor may face yields on reinvested cash
ﬂows that are lower than the yield to maturity of a security.
Relative return Difference between the realized return and the expected return.
Relative valuation A method of valuing a stock or a company that requires

using multiples of similar or comparable companies, and applying these
multiples to the stock or company.
Reoffering price The price at which an investment bank offers securities that
it is underwriting to investors.
Replacement project A project that involves the maintenance of existing assets
to continue the current level of operating activity.
Repo SeeRepurchase agreement.
Repo rate The interest rate charged in a repurchase agreement.

Repurchase agreement A short-term loan backed by speciﬁc collateral.
Required rate of return The return expected by the suppliers of capital for the
Required reserve Dollar amount of funds required to be maintained on hand,
based on the reserve ratio.
Required yield The return that investors demand, which relates to the time
value of money and the uncertainty of the security’s cash ﬂows.
Reserve ratio Percentage of deposits that a bank must maintain on hand.

Residual loss The agency costs other than monitoring costs and bonding costs.
Restricted stock grant The grant of shares of stock to the employee at low or
no cost, conditional on the shares not being sold for a speciﬁed time.
Retained earnings The accumulation of earnings over time, less dividends paid
over time.
Retention ratio The proportion of earnings retained by the company during a
period.
Return SeeRate of return.

period.
Reverse cash-and-carry trade A futures position in which the investor buys
futures, sells the asset, and lends funds at the inception of the contract, andthen buys the asset and has the loan paid off at the end of the contract.
Reverse stock split A reduction of the number of shares of stock, speciﬁed as
the number of shares post-split to the number of shares presplit, e.g., 1:4.
RIC SeeRegulated investment company.

Glossary 565
Risk Uncertainty regarding a future outcome.
Risk appetite The amount of risk that an entity is willing to accept or retain.
Risk control The process of identifying, evaluating, monitoring, and managing
the risk of an business enterprise.
Risk ﬁnance The management of the retained risk of an enterprise.

Risk management The process of identifying risks and managing those risks
through acceptance, mitigation, and transference.
Risk management culture The environment in which the entity has an ap-
proach to dealing with risks and that approach is part of the business’s
management culture.
Risk neutralization A risk management policy in which the management of
an entity pursues a risk management policy to mitigate an expected losswithout transferring the associated risk to another party.

Risk premium Additional compensation required by investors for bearing risk.
Risk retention The amount of risk an enterprise is willing to assume.
Risk tolerance The amount of risk that is tolerated, with any risk exceeding
this tolerance triggering action to reduce risk.
Risk transfer management The transfer of risk by management to a third
party via insurance, derivatives, structured ﬁnancial products, or some othermeans.
Risk-free asset An asset whose expected return is known with certainty.

Riskless asset SeeRisk-free asset.
Safety-ﬁrst rules Decision rules that seek to maximize the probabilities of pro-
ducing returns above some benchmark return.
Salary A direct payment of cash of a ﬁxed amount per period.
Sales risk The degree of uncertainty related to the number of units that will be
sold and the price of the good or service.
Salvage value The expected value of an asset at the end of its economic life.

Savings deposit Funds deposited with a bank that earn interest and can gener-
ally be withdrawn by the depositor upon demand.
Secondary market The market in which investors trade securities or other
assets.
Securities ﬁnance The borrowing or lending of securities.
Securities lending transaction The lending of securities by one party to an
investor in need of those securities on a temporary basis.
Security A ﬁnancial asset that represents a claim on future cash ﬂows, such as
a bond or a stock.

Security market line The line depicting the relation between the return on a
stock to its market risk.
Selling group A group of investment banks and others that market a security
issue.
Semi-strong form of market efﬁciency The degree of market efﬁciency in which
current prices reﬂect all available public information.

566 GLOSSARY
Semivariance A measure of dispersion that considers only the possible out-
comes below the expected value.
Separately managed account A professionally managed portfolio tailored to
the investor’s objectives.
Settlement date The designated date of the transaction in a futures contract.
Share Ownership interest in a corporation.

Shareholder Owner of an interest in a corporation.
Shareholders’ equity The ownership interest in a corporation.
Short call position An investment position that involves selling or writing call
options.
Short futures SeeShort position in futures.
Short position in futures The investment position in which the investor sells a
Short put position An investment position that involves selling or writing put
options.

options.
Silo structure The structure of a business enterprise in which each part of the
business is operated independently of the other parts of the business.
Simple interest An arrangement in which interest is paid only on the principal
amount.
SML SeeSecurity market line.
Sole proprietorship A business owned by a single individual.
Spot market SeeCash market.
Spread The difference in interest rates or yields, generally expressed in terms
of basis points.

Standard deviation of a random variable A measure of dispersion or possible
outcomes around the expected value, calculated as the square root of the
variance.
Stated conversion price The ratio of the par value of a convertible bond to the
conversion ratio.
Stated value SeePar value.
Stock appreciation right A cash payment based on the amount by which the
value of a speciﬁed number of shares has increased over a speciﬁed periodof time.

Stock dividend Distribution of additional shares of stock to shareholders, gen-
erally speciﬁed in terms of the proportion of new shares to the number ofexisting shares, e.g., 25%.
Stock option The right to buy a speciﬁed number of shares of stock in the
company at a stated price—referred to as an exercise price at some time inthe future. The exercise price may be above, at, or below the current marketprice of the stock.

Stock split Distribution of additional shares of stock to shareholders, generally
speciﬁed in terms of the ratio of shares after the distribution to the numberof existing shares, e.g., 2:1.

Glossary 567
Straight value The value of a bond without considering the value of any em-
bedded option.
Straight-line depreciation Depreciation in which the same proportion of an
asset’s cost is depreciated each period.
Strategic plan The path that the company intends to follow to achieve its
objective.
Strategy A direction the company intends to take to reach an objective.

Strike price The price at which the option buyer can buy the underlying asset,
in the case of a call option, or sell the underlying asset, in the case of a put
option.
Strong form of market efﬁciency The degree of market efﬁciency in which
current prices reﬂect all public and private information.
Structure of interest rates The relationship among interest rates of debt instru-
ments based on a number of factors, including risk and maturity.

Structured ﬁnance Securities created for speciﬁc risk and return proﬁles, such
as asset securitization and structured notes.
Style box A method developed by Morningstar to characterize securities based
on two dimensions; for stocks these dimensions are market capitalizationand style, whereas for bonds they are credit quality and maturity.
Sum-of-year’s digits method A depreciation method that uses a declining rate

applied to the asset’s depreciable basis, with this rate as ratio of the remain-ing years divided by the sum of the years.
Supranational An organization that extends beyond a single country’s bound-
aries, which shares in decision making of the organization.
Sustainability risk A broad spectrum of the risk of a business enterprise that
includes social and environmental responsibilities.
Swap An agreement whereby two parties (called counterparties ) agree to ex-
change periodic payments.

Swap curve SeeSwap rate yield curve.
Swap rate The ﬁxed rate paid by the ﬁxed-rate counterparty in a swap.
Swap rate yield curve The rates for different maturities that reﬂect the average
credit risk of banks that provide interest rate swaps.
Syndicated bank loan A bank loan in which a group of banks lends funds to a
borrower.
Systematic risk SeeMarket risk.
Systematic risk factors Factors that affect the risk of an investment that cannot
be diversiﬁed away.

Tactical asset allocation A form of dynamic asset allocation that is based on
opportunities to capture abnormal returns.
Taft-Hartley plan A pension plan sponsored by a union on the behalf of its
members.
Tangible asset An asset with physical properties, such as a machine or inven-
tory.

568 GLOSSARY
Tender offer An offer, made directly to shareholders, to purchase shares of a
company.
Three-stage dividend discount model A multiphase dividend discount model
that assumes that there are three distinct phases of growth in a stock’s
dividends in the future.
Time deposit Funds deposited with a ﬁnancial institution that have a ﬁxed

maturity date and earn interest. More commonly referred to as certiﬁcates
of deposit .
Time premium The difference between an option’s price and the intrinsic
value; the value of an option attributed to the possibility that the optionmay become more valuable in the time remaining to expiration.
Time value of an option SeeTime premium.
Time-weighted rate of return The geometric mean of subperiod rates of return.
Total asset turnover The ratio of revenues to assets; a measure of the effec-

tiveness of putting assets to use to generate revenues.
Treasury bill A short-term security issued by a government. In the United
States, these bills have maturities of four weeks, three months, and sixmonths.
Treasury securities Securities issued by a government.
Treasury spot rates The theoretical rates that would exist for a given yield
curve that represent what the U.S. Treasury would have to pay if the secu-rities are zero-coupon securities.

Treasury stock Stock of a company that is bought back by the company for
use in executive stock options and other purposes.
Two-parameter model SeeMean-variance portfolio analysis.
Underlying SeeUnderlying asset.
Underlying The basis of a derivative contract, which may be a stock, a bond,
or any other asset.
Underlying asset The asset or security speciﬁed in a derivative instrument, such
that the value and or cash ﬂows of the derivative instrument depend on thespeciﬁed asset or security.

Underwriting syndicate A group of investment banks that underwrite an issue.
Unfunded retained risk An assumed risk for which losses are not ﬁnanced until
they occur.
Unit investment trust A regulated investment that has a ﬁnite life and a ﬁxed
portfolio of investments.
Unsystematic risk factors Risks that can be reduced or eliminated through
diversiﬁcation.
Unvalued contract An insurance arrangement in which the value of the insured
property is not ﬁxed.

Upward-sloping yield curve A yield curve in which the rates of longer-maturity
securities are higher than those of shorter-maturity securities.
Useful life SeeEconomic life.

Glossary 569
Utility function A series of values assigned to possible choices that an entity
faces.
Value at risk A safety-ﬁrst rule that focuses on the maximum loss at a speciﬁed
probability level over a speciﬁed time horizon.
Valued contract An insurance arrangement in which the value of the insured
property is ﬁxed.
VaR SeeValue at risk.

Variance of a random variable A measure of dispersion or possible outcomes
around the expected value.
Variation margin The amount of margin beyond the initial margin, generally
required in cash.
Vertical common-size analysis The restatement and comparison of accounts
relative to a benchmark account’s value for that period; for a balance sheet,
this benchmark is total assets, and for an income statement this benchmarkis revenues.

Weak form of market efﬁciency The degree of market efﬁciency in which
current prices reﬂect all of the information available in past prices.
Wealth management SeeInvestment management.
Working capital Current assets, which serve to meet the needs of the day-to-
day operations of a business.
Yankee market The foreign market in the United States.
Yield curve The yields on Treasury securities at a point in time for securities
with different maturities.
Yield curve spread SeeMaturity spread.

Yield-to-ﬁrst call The yield on a callable security, assuming that the security
will be called by the issuer at the ﬁrst available call date.
Yield to maturity The expected return on a security, based on the security’s
current value, maturity value, and expected cash ﬂows, such as couponpayments.
Yield-to-par call SeeYield-to-ﬁrst call.
Yield to worst The lower of a callable security’s yield to maturity and yield to
call.

call.
Zero-coupon bond A bond that does not pay interest; rather, the investor
receives a return from buying the security at a discount from the bond’sface value.

570

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About the Authors
Frank J. Fabozzi, PH.D., CFA, CPA, is a Professor in the Practice of Finance
and Becton Fellow at Yale University’s School of Management, Editor of
the Journal of Portfolio Management, and Associate Editor of the Journal
of Structured Finance and the Journal of Fixed Income. Frank’s writingspans the gamut from the basics of corporate ﬁnance to complex structured

products and ﬁnancial econometrics.
Pamela Peterson Drake, PH.D., CFA , is the J. Gray Ferguson Professor
of Finance and Department Head of Finance and Business Law at James
Madison University. Prior to joining James Madison University, she was aProfessor of Finance at Florida State University, and an Associate Dean and
Professor of Finance at Florida Atlantic University. Pam has collaborated

with Frank in a number of books, including books on the basics of ﬁnance,ﬁnancial analysis, and ﬁnancial management. At James Madison University,
Pam teaches ﬁnancial analysis, analytical methods in ﬁnance, and advanced
ﬁnancial policy.
571

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Index
AA-rated yield curve, 486, 557
Abnormal return, 31, 557Absolute return, 54, 557
ABSs. SeeAsset-backed securities
Accelerated depreciation, 76,
557
Accounting
data, limitations, 269ﬂexibility, 83
identity, 68, 557income, adjustment, 315
irregularities, shareholder wealth
maximization (relationship),
103–104
principles, 66–67scandals, 104
Accounting Standards Codiﬁcation
(FASB), 66

(FASB), 66
Accounts payable, 71, 557Accounts receivable, 557
collection, 257current asset, 68cycle, number, 257
information, usage, 315
management, 256–257turnover, 557
ratio, 256
Accrual accounting
basis, 277
usage, 67
Accumulated comprehensive
income/loss, 72–73, 557
Accumulated depreciation, 69
Accumulated interest. SeeInterest on
accumulated interest
Acid-test ratio (quick ratio), 557Acquisitions, investment bank
assistance, 58
Active funds, 51

Active portfolio strategy, 399, 557
pursuit, 459
Active strategy, 3–4, 557Activity ratios, 245, 255–258, 557
example, 258
Actual reserve, 45, 557
Additional paid-in capital, 72, 557Adelphia, scandal, 185
Advanced-warning system, 24
Agency
business relationship, 99–101
costs, 100–101problems, 99–100
explanation, 143, 146
problem, 166
Agency costs, 100–101, 557
impact, 180reduction, stock repurchase (impact),
150
Agent, 99, 557Agreed-upon periodic rate, 376

150
Alternative asset classes, 397Alternative rate of return calculations,
advantages/disadvantages, 408e
Alternative return measures, 401–404Alternative risk measures. SeePortfolio
selection
Alternative risk transfer (ART),
196–197, 557
Amaranth Advisors, futures contract
loss, 196
American International Group (AIG),
swaps loss, 196
573

574 INDEX
American option, 373, 557
Amortization, 231Amtrak. SeeNational Railroad
Passenger Corporation
Anchoring, cognitive bias, 440Annual ﬁnancial statements,
243
Annual fund operating expense
(expense ratio), 51
Annual percentage rate (APR), 209,
211, 558
calculation, 234
conversion, 209
effective annual rate, comparison,
233–235

233–235
Annual percentage return, 557Annual return, 478Annuities, 221–230
future value, 223present value, example, 224–225value, determination, 222–223
Annuity due, 558
future value, 227valuation, 227
APR. SeeAnnual percentage rate
APT. SeeArbitrage pricing theory
Arbitrage, 371
opportunities, 461principle, 461–463
Arbitrage pricing theory (APT) model,
461–466
factors, identiﬁcation, 465–466
formulation, 463–464
Arbitrageurs, riskless proﬁt, 357

Arithmetic average rate of return,
403–404
Arithmetic average return, 208Arithmetic rate of return, 558
ART. SeeAlternative risk transfer
Articles of incorporation, 92–93,
558
Asset allocation, 393–394, 558. See also
Dynamic asset allocation; Policy
asset allocation; Tactical asset
allocation
Asset-backed bonds, 397Asset-backed securities (ABSs), 533,
558
debt security, 28
issuance, 397
Asset disposition cash ﬂows, MACRS
(usage), 314

Asset/liability management constraints,
486
Asset manager, 558Asset pricing model, 558
characteristics, 446–447
Asset pricing theory, 445Asset return
correlation, 424distributions, standard deviation,
423e
probability distribution, 421e
Assets, 68–71, 558. See also Intangible
assets; Tangible assets
acquisition, 304–306carrying value, 70classes, 392, 394–398. See also
Alternative asset classes
cost, 304covariance/correlation, calculation,
425e

425e
disposition, 306–309
importance, 309
expected return, 448, 450management, 6, 59–60, 257–258,
558
companies, 48–49, 558usage, 390
market price, adverse movement, 462purchase, accomplishment, 357retirement liability, 72, 558
salvage value, absence, 77
transformation, 19turnover, 558. See also Total asset
turnover
Asymmetric information, 23, 558
impact, 180
Atlantic option, 364, 558At-the-money option, 372, 558Attractive provisions, inclusion,
473–474

Index 575
Auction market, 30
Auction process, 30
Average credit sales per day, 558
calculation, 248
Average day’s cost of goods sold,
247–248, 558
calculation, 247
Average day’s purchases on credit,
determination, 249
Average purchases per day, 558
calculation, 249
Balanced market condition, 455
Balanced scorecard, 122–124,
558
management tool, 122process, 123e

558
Balance sheet, 266, 558. See also Pro
forma balance sheet
example, 70e, 277e
intangible asset value, 71structure, 74
Balloon payments, 231Banc of America Securities, 56Bandwagon effect, cognitive bias,
440
Bank
collateral, 45funding, 44–45loans, 5
regulation, 45–46
Bankers’ acceptance, 26, 558
short-term loans, 28
Bank holding companies, total assets,
43
Bank Insurance Fund (BIF), 46Bank of Canada, 60
Bankruptcy, 169–170, 558
costs, 169–170, 558

classiﬁcation, 170
direct costs, 170increase, 170
indirect costs, 170
likelihood, increase, 174
Base interest rate, 470–476, 558
calculation, 470Basel Committee on Banking
Supervision, risk-basedcapital requirements guidelines,46
Basic, term (usage), 356Basic earning power, calculation, 262,
264
Basic earnings per share, 76, 558Basic earnings power ratio, 262Behavioral ﬁnance, portfolio theory
(relationship), 438–441

Benchmark, 392Benchmark-based approach, 436
Bermuda option, 364, 559
Best-efforts underwriting, 57, 559Beta, 559
values, 448–449
Biased expectations theory, 484, 485,
559
Bid-ask spread, 58BIF.SeeBank Insurance Fund
Bills, current asset, 68
Biogen, Dutch auction, 148e
Bird in the hand theory, 142,
143–144
Black, Fischer, 147Black-Scholes option pricing model,
380–383, 559
Board of directors
distribution declaration, 134
ﬁduciary duty, 101

formation, 92, 93information, 145
Bond-equivalent basis, 525Bond-equivalent yield, 525Bondholder, 29
Bonding costs, 101, 559
Bond investments
categories, 397
classiﬁcation, 398e
Bond prices
change, reasons, 521–522example, 521
quotes, 523–524time, relationship, 520–521
yield to maturity, 526e

576 INDEX
Bonds, 71, 559
cash ﬂow, estimation, 533–534
debt security, 28dollar return, 531e
sources, 529–530
impact, 394investment properties, 518
issues, expected liquidity, 476
price-yield relationship, 518eproperty, 518
sale, 5
valuation, 513–524
embedded options, inclusion,
532–538
values, 519
Bonus, 559
Book value, 70, 559
Borrowing rates, differences, 361Break-even measure, 325

Brokers, commissions (absence), 136
Budget, 559
development, 114–115
Budgeting, 110, 119–120, 559. See also
Capital budgeting; Operationalbudgeting
approval/authorization, 299ﬁnancial planning, relationship,
114–115
initiation, 116process, 115–118
strategy, relationship, 111e
Bulldog market, 26
Business enterprise, forms, 90–97
Business entity, ﬁnancial
decision-making, 4–5
Business ﬁnance, 4–5, 89, 559Business forms, 95–96
characteristics, 91e
prevalence, 97e
Business risk, 186–187, 258, 559

combination, 297involvement, example, 194
Busted convertible, 538, 559Buyers/sellers, interactions, 17Bylaws, 559
adoption, 92, 93Callable bond, 473, 533, 559
valuation, 534
Callable debt, 474Call options
buyer/writer, proﬁt/loss, 368edefault right, 169purchase, 366–367
writing/selling, 367–368
Call position. SeeLong call position;
Short call position
Call provision, 473, 559
Call schedule, 528, 559Capital, 559

generation, 146investment decision, 295lease, 72, 560
loss, 529
rationing, 340–341recovery period, 324
surplus, 72
yield, 144, 560
Capital asset pricing model (CAPM),
447–460, 559
assumptions, 449–451criticisms, 460
efﬁcient frontier, relationship,
451e
tests, 459–460
utility curves, relationship, 453
Capital budgeting, 295, 559
decision, 5process, 298–303
illustration, 298e
stages, 298–299
proposal, 299
techniques, 321–343
advantages/disadvantages,
342e–343e

342e–343e
usage, 115
Capital cost, 171–175, 297, 562
calculation, example, 174echange, 173
determination, reasons, 171–172
example, 175operating proﬁt, contrast, 121–122
representation, 328–329

Index 577
Capital expenditures coverage ratio,
290
Capital gain, 307, 529
income, taxation, 144
Capital gains tax, 147
Capital-intensive companies, 290Capital market, 2–4, 28–29, 560.
See also Perfect capital market
debt, 28theory, 2, 3–4
Capital market line (CML), 451–454,
560
risk premium, calculation, 455
Capital structure, 5, 155, 560
company adjustment, 173decisions, 155–156, 176–177

differences, 158
ﬁnancial distress, relationship,
170–171
ﬁnancial leverage, relationship,
158–172
Modigliani-Miller theory,
176–180
theory, 179–180
status, 180
value, 179–180
trade-off theory, 173–174
CAPM. SeeCapital asset pricing
model
Captive ﬁnance companies, 42–43Carry, 360. See also Negative carry;
Positive carry
Carrying value, 70, 560CAS. SeeCasualty Actuarial Society
Cash
budget, 119change, 81
conversion cycle, 560
calculation, 250
current asset, 68dividends, stock distributions

(comparison), 138
equivalents, impact, 394market, 29, 560payment, amount, 93
yield, 359Cash-and-carry trade, 357–358, 560.
See also Reverse cash-and-carry
trade
Cash ﬂow, 279–283, 560. See also
Incremental cash ﬂows;
Operating cash ﬂows
analysis, 275
example, 322eusefulness, 288–290
calculation, 276
change, 80
deﬁnition, 280depreciation, contrast, 312
determination, investment (usage),
303–321
discount rates, application, 522–523entry, 119

estimate, 276estimation, example, 324e
exit, 119
funds ﬂow, 275–276generation, 80
information, usage, 291
interest coverage ratio, 560
calculation, 261
measurement difﬁculties, 275–283no-arbitrage futures price, presence,
359e
occurrence, 224, 227prediction, 117
promise, 219
receipt, assumption, 325relation, 281–282
remainder, 146
risk, sources, 296–297statement, 79–81, 279–283
example, 79e, 246e, 278e
time line, 222e, 224e, 228etiming, role, 336

uncertainty, 202
usage, 218value, change, 202
Cash ﬂow from acquiring assets,
calculation, 304
Cash ﬂow from disposing assets,
calculation, 306

578 INDEX
Cash ﬂow from ﬁnancing activities. See
Cash ﬂow from operating activities. See
Cash ﬂow from operations. See
Cash ﬂow return on investment
(CFROI), 120
Cash ﬂow series
future value, 220
occurrence, 225–226
time value, 217–221
Cash ﬂow to capital expenditures
coverage ratio, 560
calculation, 290
Cash ﬂow to debt ratio, 560

calculation, 291
Cash inﬂow (CIF), 194
positive value, 328
Cash outﬂow (COF), 194
calculation, 305
Cash settlement contracts, 352, 560
Cash value added (CVA), 120
Casualty Actuarial Society (CAS), ERM
deﬁnition, 189
Catastrophe-linked bond, 196, 560
example, 197
Catastrophic risk management, 191,
560
Cat bond, 560
CD.SeeCertiﬁcate of deposit
CDS. SeeCredit default swap
Cedar Fair, master limited partnership,
95
Certiﬁcate of deposit (CD), 395, 560.

95
See also Negotiable certiﬁcate of
deposit
written promises, 27
CFROI. SeeCash ﬂow return on
CFTC. SeeCommodity Futures Trading
Commission
Characteristic line, 458, 560
Chief Financial Ofﬁcer (CFO), function,
124–125CIF. SeeCash inﬂow
CIT Group, Inc., failure, 46Classical safety-ﬁrst portfolio, 436Classical safety-ﬁrst rules, 561
Clearinghouse, role, 353
Client-imposed constraints, 398Close corporation, 93, 561
Closed-end fund, 49, 51, 561

Closely held corporation, 93, 561Closing price, 51–52
CML. SeeCapital market line
COF. SeeCash outﬂow
Cognitive biases, 440, 561
examples, 440–441
COGS. SeeCost of goods sold
Commercial bank, 43, 561
ﬁnancial intermediary, usage, 19
services, 44
Commercial paper, 26, 561
promissor note, 27
Committee of Sponsoring
Organizations of the Treadway
Commission (COSO), ERM
Commodity Futures Trading
Commission (CFTC), 23
Commodity swap, 378, 561

Common-size analysis, 266–268, 561
Common-size balance sheet, 267Common stock, 16, 561
cost, 173example, 16impact, 394
purchase right, 534–535
style categories, 395–396valuation, 491
Companies
base, multiples (application),
508–509
borrowing dependence, 288capital cost, 172
estimation, 172–173
capital structure
adjustment, 173decisions, 176–177

Index 579
cash ﬂow exit, 119
commitment arrangement, 57
comparison, 76–77competitors, barriers (absence), 113
debt usage, 171
dividend
cuts, investor penalization,
141–142
payments, 145
economic proﬁts, generation, 126
ﬁnancial health, examination, 80
ﬁnancial restructuring, 59ﬁnancing behavior, 174
liquidity, 244
multiples
base, estimation, 507–508
calculation, 506–507

OCF, change (calculation), 317
operating performance, 244
postauditing, usage, 110
stock distribution, share price, 139strategy, effectiveness (measurement),
123
sustainability risk, 189value, change, 303
Comparative advantage, 111, 561Competitive advantage, 111–112, 561
Complementary projects, 561
dependence form, 303
Compliance, ERM risk objective, 190Component percentage ratios, 258–260
Compound average annual return, 208Compound factor, 205

Compound growth rate, 499
Compounding, 202, 561. See also
Continuous compounding
frequencies, 210e, 215–216
example, 212
multiplicity, 209–211
periods, conversion, 209
translation, 214–215
Compound interest, 204, 561
Conditional value at risk (CVaR), 436,
561
Conﬁrmation bias, cognitive bias, 440Constant discount rate, assumption,
496
Constant growth DDM, 498–500
Constant rate DDM, usage, 500
Consumer ﬁnance, transparency
(increase), 24
Consumer price index (CPI), interest
(linkage), 56

Consumer protection, enhancement, 24
Contingent projects, 302–303, 561
Continuous compounding, 211–212,
561
Contracting costs, 561
reduction, 21–22
Contract of indemnity. SeeIndemnity
contract
Conversion parity price, 536, 561
Conversion provision, 473–474, 561Conversion ratio, 534, 561
Conversion value, 561
equation, 535
Convertible. SeeBusted convertible
Convertible bond, 16–17, 76, 474,
562
conversion, 533convertible measures, 537
par value, 534–535
sale, problem, 535–536

traditional value, 535–538valuation, 534–538
example, 536e
Convertible note, 16–17, 562Convertible preferred stock, 76
Copyrights, intangible asset, 70
Core risk, 186, 562. See also Noncore
risk
Corporate bonds, 397Corporate ﬁnance, 4–5, 562Corporate ﬁnancing decision, 155
Corporate managers, takeover
defensiveness, 100
Corporate plan, 54Corporate risk management,
catastrophe-linked bonds
(usage), 196–197

580 INDEX
Corporations, 92–94, 562
balance sheets, 245e
board of directors, ﬁduciary duty,
101
capital cost, determination (reasons),
171–172
cash retention, 136characteristics, 91eD R Pb e n e ﬁ t s ,1 3 6
income statements, example, 246e
legal entity, 92market capitalization, 396
ownership, 93
shares, buyback, 148
Correlation, 562
coefﬁcient, 425
COSO. SeeCommittee of Sponsoring

Cost of capital. SeeCapital cost
Cost of carry, 360Cost of goods sold (COGS), 74, 247
usage, 254
Cost of sales, 74Cost reduction, economic function,
19
Counterparty, 351, 376, 562
risk, 355, 562
exposure, 376
Coupon interest, 514
Coupon payments, 514Coupon rate, yield/price (relationship),
519–520
Covariance, 424–425Covariance of a random variable. See
Random variable
Coverage ratio, 260–262. See also

ﬁxed ﬁnancing obligation
satisfaction, 258
indication, 261
CPI. SeeConsumer price index
Credit
events, 379
ratings, 471erisk, 186spread, 472, 562
Credit default swap (CDS), 379, 562
Creditors, 29, 562
problems, 168–169
Credit protection
buyer, 379, 562
seller, 379, 562
Credit-rating ﬁrms, transparency
Crossover rate, 562
solution, 331–332
Currency
current asset, 68
risk, 194swap, 378, 562

Current assets, 68, 244, 562. See also
Noncurrent assets
company requirement, 69
requirement, 252
types, 68–69
Current liability, 71, 244, 562
Current ratio, 244, 562
calculation, 251
Current yield, 524–525, 562
calculation, 524
yield to maturity, relationship, 526e
Customer needs, balance, 122CVA. SeeCash value added
CVaR. SeeConditional value at risk
Date of record (record date), 134, 562Days payables outstanding (DPO),
249–250

249–250
Days purchases outstanding (DPO),
563
Days sales in inventory (DSI), 563
Days sales outstanding (DSO), 563
DB.SeeDeﬁned beneﬁt
DC.SeeDeﬁned contribution
DCF. SeeDiscounted cash ﬂow
DDM. SeeDividend discount model

Index 581
Debt, 15, 563
acquisition, 17
after-tax cost, 173equity, contrast, 15–17, 156–164
ﬁnancing
governance value, 166–167
role, 161
instrument, 15, 26, 563interest payment, tax deductibility,
178–179
marginal cost, 173market values, 158obligation, ﬁxed/limited nature, 159
principal value, example, 16
ratio, 563
calculation, 157

ratio, 563
relative costs, concern, 176securities, components, 28–29tax deductibility, value, 167e
Debt-equity ratio. SeeDebt-to-equity
ratio
Debtholder, 29
Debt-to-assets ratio, 258, 563
Debt-to-capital ratio, 563Debt-to-equity ratio (debt-equity ratio),
563
calculation, 157, 259
stock repurchase ﬁt, 149
Declaration date, 563
Declining balance method, 76, 563
Default-free yield curve, 486Default right, 169
Default risk, 563
impact, 471–472

Deferred annuity, 230, 563
problems, 230
time lines, 232evaluation, 229–230
Deferred income tax liability, source,
77
Deferred tax assets, source, 77
Deferred taxes, 72
liability, 563
Deﬁned beneﬁt (DB) plan, 55, 563Deﬁned contribution (DC) pension
plans, legal forms, 55
Deﬁned contribution (DC) plan, 55,
563
Degree of ﬁnancial leverage (DFL), 563
calculation, 164
interpretation, 165

Delivery date, 351, 563Demand deposit, 44–45, 563Deposit. SeeDemand deposit; Savings
deposit; Time deposit
sources, 45
Depository institution, 43–46, 563
Depreciable basis, 76
Depreciation, 70, 76–79. See also
Accumulated depreciation
cash ﬂow, contrast, 312change, example, 319examples, 312–313
inclusion/exclusion, 311
methods, 72recapture, 307
tax shield, 563
timing, 77
Derivative contracts, types, 349–350
Derivative instruments, 23, 29, 563

company information, 83usage, shareholder concerns, 195
Derivatives, 563
market, 29risk, 195
usage, 349
hedge fund strategy, 53
DFL. SeeDegree of ﬁnancial leverage
Diluted earnings per share, 76, 563Direct costs, 170
Disability insurance, 47
Disclosure regulation, 22Discount, 519
Discount bond, price-time relationship,
520e
Discounted cash ﬂow (DCF)
methods, 503
models, 491–502techniques, application, 340–341

582 INDEX
Discounted payback period, 323, 564
payback, 326–327
Discounting, 202, 564
periods, number, 226
Discount rate, 45, 297, 564
estimation, 497
example, 215e
Discretionary cash ﬂow, 282Dispersion measures, 435Disposition cash ﬂows, straight-line rate
(usage), 309
Disposition effect, cognitive bias, 440Distributions. SeeStocks
board of directors declaration, 134types, 137–138

Diversiﬁable risk factors, 447, 564
Diversiﬁcation, 564
achievement, 21
economic function, 21
impact, 446–447
reliance, 399–400usage, 19
Diversify, term (usage), 564Dividend discount model (DDM),
492–494, 564. See also Finite
life general DDM; Three-stageDDM
examples, 494–501expected returns, relationship,
501–502
usage, 498
Dividend irrelevance theory, 142, 143Dividend-paying stocks, price volatility,
144
Dividend payout ratio, 564

144
calculation, 135
constancy, 141
equation, 493
Dividend per share, 134–135, 564
calculation, 134constant growth, 141
Dividend-price ratio, 493, 564
Dividend reinvestment plan (DRP)
(DRIP), 136–137, 564
shareholder/corporation beneﬁts, 135Dividends, 93, 133–137, 564. See also
Stocks
absence, 141cash form, 134
cutting, 145date. SeeEx-dividend date
decision, residual decision
(comparison), 143
example, 136
expected growth rate, 498
measures, 492–494
example, 494

payment
decision, 146–147
theories, 142–143
policies, 133, 141–147
puzzle, 146–147
yield, 144, 564
Dividends per share, 564
equation, 492–493
Dividends received deduction, 144–145,
564
range, 145
DJSI. SeeDow Jones Sustainability
Index
Dollar return, 564Dollar-weighted average quarterly
return, 408
Dollar-weighted rate of return,
403–404, 406–409. See also
Return
determination, 406example, 406–407
result, 407
Domestic ﬁnancial sectors, 43–60

Domestic market, 24, 564
Domestic nonﬁnancial sectors, 39–42Dow Jones Sustainability Index (DJSI),
187
Downside risk, 436–437564Downward-sloping yield curve, 482
DPO. SeeDays payables outstanding;
DRIP. SeeDividend reinvestment plan
DRP. SeeDividend reinvestment plan

Index 583
DSI. SeeDays sales in inventory
DSO. SeeDays sales outstanding
Du Pont system, 263–266, 565
Dutch auction, 147–148, 565
Dynamic asset allocation, 393, 394, 565
EAR. SeeEffective annual rate
Earnings
potential dilution, 76
quality, 288
Earnings before interest, tax,
depreciation, and amortization(EBITDA), 565
Earnings before interest and taxes
(EBIT), 254, 504

inclusion, 261
Earnings per share (EPS), 75–76, 506.
See also Basic earnings per share;
Diluted earnings per share
decline, 141increase, 149
EBIT. SeeEarnings before interest and
taxes
EBITDA. SeeEarnings before interest,
tax, depreciation, andamortization
Economic agents, 438, 565Economic factors, sensitivity, 392Economic life, 565
investment project classiﬁcation, 300
Economic modeling, 451Economic proﬁt, 121
calculation, 121e

Economic theory of choice, 416–417Economic value added (EVA), 120–122,
565. See also Reﬁned economic
value added
Economy, ﬁnancial system
(components), 3–4
Effective annual rate (EAR), 565
annual percentage rate, contrast,
233–235
calculation, 235true economic return, 234Effective rate of interest. SeeInterest
Effective tax rate, 94Efﬁcient frontier, 565
CAPM, relationship, 451e
Efﬁcient portfolio, 401, 418, 565.
See also Mean-variance efﬁcient
portfolio

portfolio
assets, inclusion, 431e, 432econstruction, 429–430feasible portfolio, 430–432
optimal portfolio, relationship,
418
reference, 429risk-free asset, combination,
452
Efﬁcient set, 430–431
optimal portfolio, choice,
432–433
8-K ﬁlings, 193Embedded option, 474
Emerging markets, 397Employee Retirement Income Security
Act of 1974 (ERISA), 55
Employee stock ownership plan
(ESOP), 55, 565
End-of-day NAV, 50–51End-of-the-day price, 51–52
Endowments, 391
Enron

Enron
earnings inﬂation, 103
scandal, 185
Enterprise, term (usage), 189–190
Enterprise risk management (ERM),
188–193, 565
application, 6CAS deﬁnition, 189
concern, 191
COSO deﬁnition, 189deﬁnition, 188–190
risk objectives, 190
scope, 191themes, 191–192
illustration, 192e
Entity, risk policy speciﬁcation, 193EPS. SeeEarnings per share

584 INDEX
Equity, 72–73, 155, 565. See also
Investor; Owners
book value, 259
components, 28
debt, contrast, 15–17, 156–164ﬁnancing, 159
obligation, absence, 157
free cash ﬂow, 567instrument, 16, 565
investment style, 395, 565
market values, 158, 260
owners, rewards, 165
portfolios, benchmarks, 392relative costs, concern, 176
return, 160
example, 161e

Equivalent taxable yield, 473, 565ERISA. SeeEmployee Retirement
Income Security Act of 1974
ERM. SeeEnterprise risk management
ESOP. SeeEmployee stock ownership
plan
ETF. SeeExchange-traded fund
Eurodollar CD, 27
Euromarket, 26, 565European Central Bank, 60
European Investment Bank, 60
European option, 364, 373, 565European Union companies, IFRS
usage, 84
EVA. SeeEconomic value added
Evaluation period, 401
Excess margin, 354
Excess reserve, 45, 565
opportunity cost, 45

Exchange, 31, 565Exchange-traded fund (ETF), 49,
51–52, 566
assets, growth, 52epremiums/discounts, 52
Ex-date, 134, 566
Ex-dividend date, 134, 566
Executive compensation, 101–104
performance, relationship (absence),
102–103
Exercise price, 566Exercise style, 364
Expansion project, 566
impact, 301
Expectations theory, 484, 566. See also
Pure expectations theory
Expected cash ﬂows
estimation, 4, 514present value, 328
calculation, 4

Expected dividends per share, 495Expected portfolio returns, 415–416
Expected return, 450
calculation, 420–421
dividend discount models,
relationship, 501–502
estimation, example, 502
Expected shortfall, 566
Expected tail loss, 566Expense ratio, 51, 566
Expenses
cash outﬂow, 315–316
change, 310–311, 317–318
example, 319
Expiration date, 367Explicit costs, 18
Ex post return, 419
External management, plan sponsor
option, 55
External market, 26, 566Extra dividends, 134

periodic payments, 141
Extra special dividends, 142e
Face value, 566
Factors, 446Fairness opinion, 59
Fair price, 507
FASB. SeeFinancial Accounting
Standards Board
FDIC. SeeFederal Deposit Insurance
Feasible portfolio, 430–432, 566
assets, inclusion, 432e
Fed discount window, 45, 566Federal Deposit Insurance Corporation
(FDIC), 46

Index 585
Federal depository insurance, initiation,
46
Federal funds market, 45, 566
Federal funds rate, 45
Federal government, 39
Federal Home Loan Mortgage
Corporation (FHLMC),
government-sponsored
enterprise, 40–41
Federal National Mortgage Association
(FNMA), government-sponsoredenterprise, 40–41
Federal Reserve Board, 46
Federal Reserve (Fed), 37
borrowing, 45

FHLMC. SeeFederal Home Loan
Mortgage Corporation
Fiduciary duty, 101, 566
FIFO. SeeFirst-in, ﬁrst-out
Finance, 566
deﬁnition, 15explanation, 2
ﬁeld, components, 2–3, 3e
math, 201relationship, 2e
Financial Accounting Standards Board
(FASB), 66, 83
Accounting Standards Codiﬁcation,
66
IASB, cooperation, 84
Financial activities
regulation, 22–24regulators, 14
Financial analysis, 566Financial assets, 14, 566
creation, assistance, 20
management, 20

requirement, reasons, 14–15trading, facilitation, 20
Financial calculators, usage, 206, 334,
516
Financial decision-making, tools, 2
Financial distress, 157, 168–171, 566
bankruptcy costs, 169–170
capital structure, relationship,
170–171direct/indirect costs, absence, 166
increase, 171
taxes, trade-off, 176
Financial distress costs, 169–171
absence, 178–179capital structure theory, relationship,
179–180
present value, increase, 171

179–180
Financial economics, 566
reference, 1–2
Financial factor, involvement, 194Financial ﬂexibility, leverage
(relationship), 165–166
Financial guarantee insurance, 48Financial Industry Regulatory
Authority (FINRA), 23
Financial institution regulation, 22, 24Financial instrument, 13, 566
purchase/sale, hedge fund strategy,
53
Financial intermediaries, 3, 14, 566
funds, acquisition, 19
role, 15e, 18–24
staff, maintenance, 22
Financial leverage, 245, 258–262,
566

566
158–162
degree. SeeDegree of ﬁnancial
leverage
elevation, 165
effect, isolation, 178ratios, example, 262
risk, relationship, 164–167
Financial management, 2, 4–6, 566
objective, 97–104owner wealth maximization,
relationship, 99
Financial managers, decisions, 6Financial markets, 3, 14
economic unction, 17–18
provision, 17–18
role, 17–18
types, 24–32
Financial measures, 123
Financial needs, 122

586 INDEX
Financial planning, 109, 566
budgeting, relationship,
114–115
components, 114–115
Financial plans, formulation, 114
Financial ratios
analysis, 243
usage, 268–270
classiﬁcation, 244–247usage, 245
Financial regulators, 3Financial restructuring, 567. See also
Companies
investment bank involvement,
58–59
Financial risk, 258, 567
components, 186management, 185

Financial Services Authority (United
Kingdom), 53
Financial services holding companies,
afﬁliation, 56
Financial slack, 165Financial statements, 65
basics, 67–81
creation, assumptions, 66–67
footnotes, examination (reasons),
82–83
Financial strategic plan, 5Financial strategy, 109
Financial system, 13–17. See also
United States
components, 14, 37
Financial theory, 439
Financing
activities, cash ﬂow, 80, 560
comparison, 234
cost, 359decisions, 5

Finite-life general DDM, 495, 567
assumption, 498–499example, 496
inputs, 496–497
FINRA. SeeFinancial Industry
Regulatory AuthorityFirm, free cash ﬂow, 567Firm commitment
effort, 57
offering, 567
underwriting, 57
First-in, ﬁrst-out (FIFO), 83, 567
Fitch Ratings, 471
Fixed asset, 567
Fixed ﬁnancing obligations,
Fixed income equivalent, 538, 567Fixed income instruments, 15Flat yield curve, 482, 567
Flotation costs, 146

FNMA. SeeFederal National Mortgage
Association
Ford Motor Credit, captive ﬁnance
company, 42–43
Forecasting
importance, 118regression analysis, usage, 117
Foreign currency
changes, exposure, 363translation adjustments, 81
Foreign investors, 60
Foreign market, 24, 26, 567
Foreign participants
government regulation, 24regulation, 22
Formulae, intangible asset, 71
Forward-looking P/E, 505
Forward rate, 477–481, 567
prediction ability, 480

Forwards, derivative contracts, 349Forwards contracts, 350, 355–362
position, liquidation, 352–353
pricing, basics, 355–360
usage, 362–363
Forward stock split, 137, 567
share price, 139
Foundations, 391401(k) plans, 55
Framing, 567
cognitive bias, 440
Franchises, intangible asset, 70

Index 587
Free cash ﬂow, 146, 287, 567
calculation, 288
reduction, dividend payment
(impact), 146
Free cash ﬂow to equity. SeeEquity
Free cash ﬂow to the ﬁrm. SeeFirm
Freeport-McMoran, special dividend
payments, 142e
Front-loaded cash ﬂows, 325FTSE4Good Index, 189
Full disclosure, requirement, 67
Fully amortizing loan, 231Fundamental factor models, 465
Funded retained risk, 567

Funding entity, government-sponsored
enterprise, 41
Funds
acquisition, ﬁnancing decisions,
89
long-term sources, 172transference, 14–15
Future cash ﬂows, dividends
(comparison), 492
Future dividends, investor anticipation,
98
Futures
derivative contract, 349
long position, 570
price, 350–351, 567
Futures contracts, 350–363, 567.
See also Next futures contract
initial margin/variation margin,
absence, 358

legal agreement, 350options, differences, 365–366position, liquidation, 352–353
sale, 362–363usage, 362–363
Future value
calculation, 203–213
example, 207
determination, compound interest
(impact), 205
even series, 223–224present value, relationship, 214
representation, 220
time line, 218e
GAAP. SeeGenerally accepted
accounting principles
Gambler’s fallacy, cognitive bias, 441
GDP. SeeGross domestic product

General Electric Credit Corporation,
captive ﬁnance company, 43
Generally accepted accounting
principles (GAAP), 66, 568
framework, 83
General Motors (GM), earnings per
share decline, 141
General partnership, 91–92, 568Geometric average return, 208
Geometric mean return, 405GIC. SeeGuaranteed investment
contract
Global banking, bank service, 44Global Partners, master limited
partnership, 95

Global Reporting Initiative (GRI), 187Going concern, business continuation,
67
Golden parachutes, 100
Goldman Sachs, 56
bonds, 397
debt. SeeUnited States
disclosure regulation, justiﬁcation,
22–23
sector, 39–42
subsidy, representation, 163
Government-owned corporation,
39–40, 568
Government-sponsored corporation,
41
Government-sponsored enterprise
(GSE), 40–41, 568
types, 40–41
Grant, W.T., 292Greenhill & Company, 56GRI. SeeGlobal Reporting Initiative

588 INDEX
Gross domestic product (GDP). See
sectors, contribution, 37
Gross plant and equipment, 69,
568
Gross proﬁt margin, 568
calculation, 253
Gross property, plant, and equipment,
69, 568
Gross spread, 57
Growth patterns, three-phase model
design, 501
Growth rates, 208
equation, 216–217
examples, 209, 211multiplicity, 212–213
GSE. SeeGovernment-sponsored
enterprise

Guaranteed investment contract (GIC),
47–48, 392
Half-year convention, 77Health insurance, 47Hedgeable rate, 480–481, 568
Hedge funds, 49, 53–54, 568
institutional investor, 391operation, 54
strategies, 53
Heuristic, term (usage), 568
Heuristic-driven biases, 440
High-credit-quality entities,
counterparties, 355
High grade, term (usage), 472High-yield bonds, 472Historical costs, usage, 84
Holding period return, 419, 568

Homogeneous expectations, 453Horizontal common-size analysis,
266–268, 568
example, 269e
Houlihan Lokey Howard & Zukin,
56
Humped yield curve, 482, 568Hybrid pension plan, 55–56IASB. SeeInternational Accounting
IFRS. SeeInternational Financial
Reporting Standards
Illegal insider trading, 23, 568Implicit costs, 18Incentive fee, 54
Income, double taxation, 94
Income statement, 74–79, 266, 568.
See also Pro forma income
statement

statement
example, 75e, 246e, 278estructure, 75e
Income taxes
classiﬁcation, 281company information, 82
Incorporation, articles, 92–93, 558Incremental cash ﬂows, 303, 568Indebtedness, representation, 28
Indemnity contract, 195
Independent directors, 93, 568Independent projects, 302, 336–337,
568
Indexed funds, 568Indifference curves, 416–418, 433
illustration, 417e
Indirect costs, 170
Individual banking, bank service, 44

Individually managed account, 568Individually sponsored plan, 54, 568
Industry, economic proﬁt generation
ability, 126
Industry-speciﬁc multiples,
determination, 506
Information asymmetry, 14, 568
Information processing
cost reduction, 21–22time, opportunity cost, 21–22
Initial cash ﬂow, example, 305–306
Initial margin, 353, 568
requirement, variation, 354–355
Innovation, needs, 122Inside directors, 568Institutional banking, bank service, 44

Index 589
Institutional investors
components, 391
Institutional investors, borrowing cost
(absence), 362
Institutional portfolios, 395
Insurance, 195
companies, 47–48
institutional investor, 391
premium, 195, 569products, sale, 47–48
Insurance-linked note, 196, 569Intangible assets, 14, 70–71, 569Interbank yield curve, 569
Interest
amount, calculation, 231
creditor expectation, 156

deductibility, 162–164, 178
government subsidy representation,
163
effective rate, 234, 565
expense
cash ﬂow, relationship, 281
usage, 163
income, 281
tax treatment, 471U.S. federal tax code speciﬁcation,
474
taxability, 474–475
tax deductibility, beneﬁt (increase),
171
tax shield, 178, 569
calculation, 163
Interest-bearing instruments, 353
Interest-bearing ratio, 259
Interest coverage ratio, 569
calculation, 260
company information, 260–261

Interest on accumulated interest, 204
Interest on interest, 204
Interest rate, 217. See also Base interest
rate; Real interest rate
calculation, 470–471determination, 4, 216–217
differences, 213structure, 469, 579swap, 376–377, 569
usage, reason, 377
term structure, 476–483
theories, term structure, 484–486
yield, relationship, 232–238
Interim cash ﬂows, 361
Intermediaries, 13
Internal management
needs, 122
plan sponsor option, 55

needs, 122
Internal market, 569
Internal rate of return (IRR), 235–236,
323569. See also Modiﬁed
internal rate of return; MultipleIRRs
cross-over rate, contrast, 331–332decision rule, 335discount rate, comparison, 337
problems, 336
usage, 333–338yield, comparison, 334
International Accounting Standards
Board (IASB), 83
FASB, cooperation, 84
International Bank for Reconstruction
and Development, 60
International Financial Reporting
Standards (IFRS), 84

International market, 26
In-the-money option, 569
Intrinsic value, 371–373, 569
difference, 372
Inventories, 569
current asset, 68ﬂows, 257
level, reduction, 318
management, 256, 390reduction, 252, 320
turnover, 31
calculation, 256
ratio, 256
Inverted yield curve, 482, 569Investable assets, 395eInvested capital, resource level, 122
Investment banker funds, raising, 57

590 INDEX
Investment banking companies,
classiﬁcation, 56–57
Investment banks, 56–60
classiﬁcation, 56
Investment cash ﬂow, 304–309
present value, 303
Investment companies, 48–49,
569
Investment management, 2–3, 6–7, 389,
569
activities, 7e
process, 390e, 400–401
Investment objectives
classiﬁcation, 391–392setting, 7, 391–392
Investment-oriented products,
47–48

47–48
advice, provision, 20
client-imposed constraints, 398
comparison, 234consideration, 226
decisions, 296–298
discontinuation, 104evaluation techniques, 323–324
factors, 398–399
future value, example, 206e
impact, 314
manager, 569outlay, absence, 357
policy, establishment, 393–400
present value, 204proﬁle, 330–331, 569
example, 331e
projects, classiﬁcation, 300–303regulatory constraints, 398–399
return, increase, 167
risk indication, payback period

(usage), 326
screening/selection, 298–299strategy, 110tax considerations, 399
uncertainty, 214
unrealized gains, 81value, 569
yields, 235–238Investor, 569
equity, 569
risk expectations, 394
IRR. SeeInternal rate of return
Irrelevance proposition (M&M),
177–178
Issuer, 569
Joint venture, 96, 570
JPMorgan Securities, 56
Junk bonds, 472
Kahneman, Daniel, 438–439
Kaplan, Robert, 122Kellogg, dividend payments, 141
Keynes, John Maynard, 438

Key performance indicators (KPIs),
570
measures, 123
KPIs. SeeKey performance indicators
Krispy Kreme, analysis, 289–290
Lagging indicators, 122–123
Largay, James, 292
Large capitalization stocks, 396
Last-in, First-out (LIFO), 83, 570
Law of one price, 461
Leading indicators, 122–123Leases. SeeCapital lease
company information, 82payments, 258
Legal risk, 186
Lending rates, differences, 361
Letters of credit (LOCs), 46Leverage

availability, 354–355ﬁnancial ﬂexibility, relationship,
165–166
hedge fund strategy, 53usage, example, 162, 164
Leveraged portfolio, 570
Leveraging, 354–355
Liabilities, 68, 71–72, 570Liability-driven objectives, 391, 392
Liability-driven strategies, 400
Liability insurance, 47

Index 591
LIBOR. SeeLondon Interbank Offered
Rate
Life insurance, 47
LIFO. SeeLast-in, First-out
Limited liability, 570
role, 168–169
Limited liability company (LLC),
94–95, 570
Limited liability partnership (LLP),
94–95, 570
Limited partner, 92Limited partnership, 92Linear payoff, 366
Lintner, John, 447
Liquidity, 17, 245–253, 570
impact, 18
measures, 251–252
premium, 570ratios, 253

risk, 570
theory, 485, 570
Listed, term (usage), 31, 570
LLC. SeeLimited liability company
LLP. SeeLimited liability partnership
Loan amortization, 230–232, 570
example, 233e
Loan payments, calculation process,
230–231
Local government, issuer/investor role,
41–42
LOCs. SeeLetters of credit
London Interbank Offered Rate
(LIBOR), 376–377, 486,570
Eurodollar CD interest rate, 27
Long call position, 366–367, 570Long futures, 351, 570

Long position, 351Long position in futures. SeeFutures
Long put position, 369, 570Long-run planning, 115, 570Long-term assets, decisions, 300
Long-term borrowers, interest rate
(elevation), 20
Long-term capital, focus, 158Long-term care insurance, 47Long-term debt
company information, 82
exclusion, 259
Long-term indebtedness, 71
Long-term investing, funds
procurement, 5
Long-term liability, 571
types, 71–72
Long-term planning, 115, 571
Lost sales, ﬁnancial distress cost, 169

Lower partial moment, 436
risk measure, 436–437
Low-risk investments, 395Lump-sum, present/future value
(calculation), 232–233
M&A. SeeMergers and acquisitions
MACRS. SeeModiﬁed Accelerated Cost
Recovery System
MAD. SeeMean-absolute deviation
Maintenance margin, 353, 571
Management
focus, 112–113forecasts, 118. See also Sales
performance, evaluation, 110
Managers, motivation (executive
compensation), 101–104
Mandated project, 571

government requirement, 301
Marginal tax rate, 571
calculation, usage, 173
Margin requirements, 353–354Market, 13
anomaly, 571capitalization (market cap), 97–98,
571
example, 98
conversion price, 536, 571liquidity risk, 186
makers, 31
price efﬁciency, 400risk, 186, 447, 571
structure, 30, 571. See also
Order-driven market structure;
Quote-driven market structure
surveys, 118

592 INDEX
Marketable securities, 571
Market conversion premium per share,
571
equation, 537
Market conversion premium ratio,
Market efﬁciency, 31–32
issuer implications, 32
semi-strong form, 32, 578
strong form, 32, 579
weak form, 32, 581
Market segmentation theory, 485–486,
571
Market value added (MVA), 120, 122,
571
Market value of shareholder equity. See

571
Shareholders
Market value to book value (MV/BV)
ratio, 503–504
Markowitz, Harry, 7, 190, 421–422,
450
formulation, 422–423. See also
Portfolio theory
Markowitz diversiﬁcation, 571
strategy, 426–427
Mark-to-market requirements, absence,
356
Master limited partnership (MLP),
95–96, 571
ownership interests, 96
Matador market, 26Matching principle, usage, 67
Maturity intermediation, 20–21,
571
economic function, 19
Maturity spread, 476, 571

Maturity value, 514–515, 571MBSs. SeeMortgage-backed securities
Mean-absolute deviation (MAD), 435,
571
Mean return, 450
Mean-standard deviation, 571
Mean-variance analysis, 424, 437, 450,
571Mean-variance efﬁcient portfolio, 430,
572
Medium-term notes, debt security, 28Merchant banking, 572
activity, 59
Mergers, investment bank advice,
58–59
Mergers and acquisitions (M&A),
58–59
Mid-capitalization stocks, 396
Miller, Merton, 143, 176–178

irrelevance proposition, 177–178
Minority interest, 572
information, 73
MIRR. SeeModiﬁed internal rate of
return
MLP. SeeMaster limited partnership
MMDA. SeeMoney market demand
account
Modern portfolio theory (MPT), 190,
572
Modiﬁed Accelerated Cost Recovery
System (MACRS), 77–79, 572
asset, 320
depreciation, 79
rates, 313e
rates, 77e
usage, 312, 314, 338–339
Modiﬁed internal rate of return
(MIRR), 323, 572
example, 340e
Modigliani, Franco, 143, 176–178

irrelevance proposition, 176–177
Money
management, 6, 390, 572
manager, 390, 572
market, 26–28, 572
time value, 326value, determination, 201–203
Money market accounts, 395Money market demand account
(MMDA), 45, 572
Money purchase pension plans, 55Money-weighted rate of return, 406,
572

Index 593
Monitoring costs, 572
Monsanto Company, entry barriers,
112
Monte Carlo simulation model, 534Moody’s Investors Service, 471Mortgage-backed securities (MBSs),
533, 572
Mossin, Jan, 447Most distant futures contract, 352
MPT. SeeModern portfolio theory
Multifactor risk models, 464–465
Multiphase DDM, 500–501
Multiple growth rates, 212–213
Multiple IRRs, 337eMunicipal bonds, 397

Municipal yield ratio, 475, 572
Muni-Treasury yield ratio, 475, 572Mutual funds, 50–51
Mutually exclusive projects, 302, 335,
572
MVA. SeeMarket value added
MV/BV. SeeMarket value to book
value
National market, 24, 572
National Railroad Passenger
Corporation (Amtrak),
government-owned corporation,
39–40
NAV. SeeNet asset value
NCF. SeeNet cash ﬂow
Nearby futures contract, 352, 572

Negative bias, cognitive bias, 441Negative carry, 360
Negative investing cash ﬂows, 80
Negative net present value, 330Negotiable certiﬁcate of deposit, 26,
572
investor purchase/sale, 27
Net asset value (NAV), calculation, 50
Net cash ﬂow (NCF), 80, 319–320, 573
calculation, 320
Net ﬁnancing cost, 359
cost of carry, term, 360Net income, 267
examination, 82
Net operating cycle, 573Net plant and equipment, 69, 573
Net present value (NPV), 323, 573

decision rule, 329–330
example, 333
proﬁle, 330–331quality, 335
usage, 327–332
Net proﬁt margin, 573
calculation, 254
Net property, plant, and equipment, 69,
573
Net working capital, 247, 573
change, 316
cushion, 252increase, 314
Net working capital to sales ratio, 252,
573
New products/markets, 301New York/New Jersey Port Authority,
41
New York Stock Exchange (NYSE), 31
MLP listing, 95

Next futures contract, 352, 573Nintendo, sales forecast example,
116–117
No-arbitrage futures price, absence,
359e
Nominal interest rate, 234
Non-bank lenders, regulation
Noncash expenditures, 80Noncore risk, 185, 573
Noncurrent assets, 69Nondepository ﬁnancial institutions, 46
Nondiversiﬁable risk factors, 447, 573
Nonﬁnancial businesses, 42–43Non-ﬁnancial measures, 123
Nonﬁnancial stakeholder issues, 180

Noninvestment-grade bonds, 472Nonliability-driven objectives, 391–392
Nonlinear payoff, 573

594 INDEX
Nonsystematic risk, 573
reduction, diversiﬁcation (usage),
457
Nontraditional asset classes, 397
Non-Treasury issues, expected liquidity,
471
Non-U.S. corporations, securities
issuance, 26
Norton, David, 122
Note, 573
Noteholder, 29Notes payable, 71, 573
Notional amount, 376, 573
Notional principal amount, 376, 573NPV. SeeNet present value

Number of days of credit, 248, 573Number of days of inventory, 573Number of days of purchase, 249–250,
573
NutraSweet Company, entry barriers,
112
NYSE. SeeNew York Stock Exchange
OCF. SeeOperating cash ﬂows
Off-balance sheet obligations, 46Ofﬁce of the Comptroller of the
Currency, 46
Offshore market, 26, 573Open-end fund, 49, 50, 573
Open interest, 573
Open market purchases, 147Operating activities, cash ﬂow, 560
Operating cash ﬂows (OCF), 303,
309–313, 573
analysis, 309calculation, 317–319

change, 317–318classiﬁcation, 281
present value, 304
taxes, impact, 311
Operating cycle, 247–250, 573
calculation, 249examples, 69e, 250investment conversion, 250Operating earnings, 262
decrease, 171example, 162–163
Operating income, 74Operating performance, 244
aspects, 245
Operating proﬁt, capital cost (contrast),
121–122
Operating proﬁt margin, 573
calculation, 254decline, 265
Operating risk, 187, 296, 573
determination, 297

Operational budgeting, 115, 573Operational risk, 186
Operational risk management, 125
cash ﬂow, 80, 81, 560
ERM risk objective, 190
Optimal capital structure, 573
theory/practice, 175–180
Optimal portfolio, 418, 432–433, 574
efﬁcient portfolios, relationship, 418
selection, 433e
Option buyer
loss maximum, 365
proﬁt/loss proﬁle, 368
Option holder, 364
Option life

anticipated cash payments, 373, 375expected volatility, 373, 374short-term risk-free interest rate, 373,
374–375
Option premium, 364, 574Option price, 364, 574
components, 371–375factors, 373–375
list, 374e
Option pricing model, 375. See also
Black-Scholes option pricingmodel
Options, 363–376
derivative contract, 350expiration date, 370
features, 363–365

Index 595
futures contracts, differences,
365–366
intrinsic value, 371
risk/return, 366–371
strike price, 373
time to expiration, 373–374time value, 372–373, 580
usage, 375–376
Option writer, 364, 574
Order-driven market structure, 30,
574
Ordinary annuity, 224, 574Oriental Land, Co, catastrophe-linked
bonds (usage), 196–197
OTC. SeeOver-the-counter

Out-of-the-money option, 372, 574
Outside directors, 93, 574Overall asset management, 257–258
Overconﬁdence bias, cognitive bias,
441
Over-the-counter (OTC) derivatives,
46, 379
Over-the-counter (OTC) market, 31,
574
Over-the-counter (OTC) option, 365
Owners
downside potential earnings, 164earnings, risk (increase), 171economic well-being, measurement,
97–99
equity, 155, 574limited liability, 168
upside potential earnings, 164
wealth, 296–298

decrease, 169
maximization, 99
Ownership interests, 73, 96
sale, 5
Par, present value, 515
Partnerships, 90–92, 574. See also
General partnership; Limitedpartnership; Master limitedpartnershipagreement, 91
limitation, 92
disadvantage, 92
Partnership share, 16, 574
Par value, 72, 574
Par value at maturity, 514
Passive funds, 51, 574Passive portfolio strategy, 399, 574
Passive strategy, 4, 574

Patents, intangible asset, 70Payback method, usage, 325–326
Payback period, 323, 574
usage, 324–326
Payment date, 134, 574Payoff period, 324
Payout ratio. SeeDividends
PBC. SeePeople’s Bank of China
Pension funds, 49, 54–56Pension plans, company information,
82
People’s Bank of China (PBC), 60Perfect capital market, 143, 178Performance
attribution models, 410evaluation, 120–124, 401–410, 574.
See also Management
measure, 409–410
executive compensation, relationship

(absence), 102–103
indicators, 124emeasurement, 401–410
motivation, stock options (usage),
102
shares, 101, 574transaction costs, impact, 401
Periodic coupon interest payments, 514
issuer creation, 530
Periodic interest payments,
reinvestment income, 529
Period notation, 218Perpetuity, 574
example, 226
valuation, 225–226
Physical property, 395

596 INDEX
PI.SeeProﬁtability index
Planning process, evaluation, 110
Plan sponsor, 574
options, 55
Plowback ratio, 574Policy asset allocation, 393, 574Porter, Michael, 126
Porter’s ﬁve forces, 126e, 575
disadvantages, 128
threats/powers, 127e
Portfolio, 390, 575
construction, 400–401cost, 462–463
creation, 463–464
diversiﬁcation, 426–428expected return, 430e
estimation, 418–421

investment set, 7management, 6, 390, 575
manager, 575
monitoring, 400–401nonliability objective, 392
risk-return combination, 432
robust optimization, 437–438selection theory, issues, 434–438
strategy. SeePassive portfolio strategy
classiﬁcation, 7selection, 399–400
variance, 454
Portfolio M,455
Portfolio return
calculation, 402–403
expression, 402
variance, 457
Portfolio risk
acceptable levels, 415–416components, 457e
correlation, 427–428measurement, 421–426
objective, 392

Portfolio selection
alternative risk measures, 434–435concepts, 416–418
goal, 415–416theory, 7, 415Portfolio theory
behavioral ﬁnance, relationship,
438–441
Markowitz formulation, 422–423
Position, liquidation, 352–353Positive carry, 360Positively sloped yield curve, 481–482,
575
Positive net present value, 329–330Postauditing, usage, 110
Post-completion audit, 299
Postpayback duration, 575Post-payback duration, 325
Power index, 437

Preferred habitat theory, 485, 575Preferred shareholder, creditor
seniority, 172
Preferred stock, 16, 575
cost, 173
dividends, 260
Premium, 519–520, 575
Premium bond, price-time relationship,
522e
Prepayment, 575Present value, 203
calculation, 213–216, 220, 328calculator, usage, 215
determination, 219
examples, 215e, 216formula, 221
future value, relationship, 214
time line, 219e, 221e
Pretax earnings, minimum
requirements, 31
Price, coupon rate/yield (relationship),
519–520

519–520
Price discovery, 17, 575Price/earnings ratio (P/E ratio), 503
averaging, 506–507
comparison, 504–505
Price-earnings ratios, 399
Price efﬁciency, 3, 575
Price-efﬁcient market, 31–32
Price-to-book value per share (P/B)
ratio, 396

Index 597
Price/X ratios, 503, 504
Price-yield relationship, 518ePrimary market, 30, 575
Prime brokerage securities, 59
Principal, 575
Principal repayment, 258
Private placement. SeeSecurities
offerings, 30
Private plan, 54, 575Probability distribution, 575
Procter & Gamble
common stock, example, 16
interest rate swap loss, 196

Production cost, changes, 254Professional corporation, 96, 575Proﬁtability index (PI), 323, 575
example, 333NPV information, usage, 332–333
Proﬁtability ratio, 245, 253–255, 575
example, 255indication, 255
Proﬁt margin. SeeGross proﬁt margin;
Net proﬁt margin; Operatingproﬁt margin
ratio, 253
Pro forma balance sheet, 120, 575Pro forma income statement, 120, 575
Project, 295. See also Independent
projects
cash ﬂow
analysis, 321

projects
cash ﬂow
consideration, 337estimation, example, 324e
choice, 335classiﬁcation. SeeInvestments
dependence, investment project
classiﬁcation, 302–303
discounted cash ﬂow techniques,
application, 340
evaluation, 317NPV, 333–334OCF, present value, 304
payback period, 324–326result, 316tracking, 299
working capital, change, 316
Property and casualty insurance, 47
Proprietary trading (prop trading), 58
Prospect theory, 439, 575Public corporation, 576
shares, trading, 93

Publicly held corporation, 93, 576Publicly-traded companies,
compensation disclosure, 102
Public market offerings, 30Public pension funds, 42
Public plan, 54
Pure expectations theory, 484–485,
576
Putable bond, 473, 533, 576
Put options, 364
buyer/writer, proﬁt/loss, 371epurchase, 369–370, 375writing/selling, 370–371
Put position. SeeLong put position;
Short put position
Put provision, 473, 576
Quadratic programming, 429–430

Quantitative risk-return optimization,
application, 437
Quarterly compounding, example,
210–211
Quarterly ﬁnancial statements, 243
Quick assets to current liabilities,
two-for-one ratio, 251–252
Quick ratio (acid-test ratio), 557
Quote-driven market structure, 31,
576
covariance, 562standard deviation, 578
variance, 422
Rate of return. SeeReturn
Rating agencies, 471, 576

598 INDEX
Ratios
analysis, 290–291
application, 245
interpretation, 269
Ratios, classiﬁcation, 244–245
R&D. SeeResearch and development
Real estate, impact, 394Real interest rate, 470, 576Record date. SeeDate of record
Reference entity, 379Reference rate, 376Reﬁned economic value added (REVA),
120
Regression analysis, 117, 576Regression line, 576
Regulated investment company (RIC),

49–51, 576
assets, 49ecosts, types, 51
institutional investor, 391investor cost, 51
types, 49
Regulatory constraints, 398–399
Reinvestment rate, 339
assumption, 336yield to maturity, relationship,
530–532
Reinvestment risk, 473, 576Relative return, 54, 576
Relative valuation, 576
methods, 503–509
principles, 504–505
process, 505e
Relative value, assessment, 498
Rembrandt market, 26
Reoffering price, 57, 576
Replacement project, 576
components, 301

Repo. SeeRepurchase agreement
Reporting, ERM risk objective, 190Repurchase agreement (repo), 26, 59,
576
rate, 27short-term borrowing, 27
Required rate of return (RRR), 297,
576Required reserve, 576
Required yield, 577
Research and development (R&D),
investment, 71
Reserve ratio, 45, 577Residual loss, 101, 577Residual value, 76
Restricted stock grant, 102, 577
Retail stores operation, 115Retained earnings, 72, 577
Retained risk, 193–194. See also

Funded retained risk
Retention ratio, 577
Retirement beneﬁts, basis, 56
Retirement programs, company
information, 82
Return, 401–402, 577. See also
Absolute return; Portfolio
return; Relative return
arithmetic return, 558
deﬁnition, 208
dollar-weighted rate, 564
internal rate. SeeInternal rate of
return
leverage, usage (example), 162measures. See also Alternative return
measures
probability distribution, 421erate, 401–402, 576. See also

Money-weighted rate ofreturn; Time-weighted rate ofreturn
required rate. SeeRequired rate of
return
Return on assets (ROA)
calculation, 263, 265examination, 264
Return on equity (ROE)
calculation, 263, 265dissection, 264example, 266
ratio, breakdown, 265
Return on investment (ROI), 245,
262–263
ratios, 262

Index 599
REVA. SeeReﬁned economic value
added
Revenues, change, 310, 317–318
Reverse cash-and-carry trade, 358, 361,
577
Reverse stock split, 137, 577RIC. SeeRegulated investment
company
Risk, 577
aggregate, 193–194
appetite, 577
aversion, 450classiﬁcation, 186
corporate acceptance, 186
deﬁnition, 185factors, 446. See also
Nondiversiﬁable risk factors;Unsystematic risk factors

ﬁnance, 193–194, 577
164–167
investment project classiﬁcation,
301–302
measurement, 3, 417
variance/standard deviation,
422–423
neutralization, 194, 577policy, speciﬁcation, 193
premium, 446–447, 470–471, 577
default risk, impact, 471–472
reduction, diversiﬁcation (usage), 19,
21
retention, 577
decision, 193
tolerance, 577transfer, 194–195
management, 195
Risk-based capital requirements, 46Risk control, 577
derivatives, usage, 349process, 191

Risk-free asset, 450, 577
consideration, absence, 451–452efﬁcient portfolio, combination,
452
rate of return, example, 458risky asset, contrast, 418
Riskless asset, 577
Risk management, 193–197, 577.
See also Catastrophic risk
culture, 577
SOA deﬁnition, 192
decision, 193importance, 6
mishaps, derivatives (impact), 196
processes, 6
Risk-return combinations, 417
Risk sharing instruments, 362
Risk transfer management, 577Risky assets

portfolio, 420–421
selection, 428–433
risk-free assets, contrast, 418
ROA. SeeR e t u r no na s s e t s
Robust portfolio optimization, 437–438ROE. SeeReturn on equity
ROI. SeeReturn on investment
RRR. SeeRequired rate of return
Safety-ﬁrst risk measures, 435–437Safety-ﬁrst rules, 577
Salaries payable, 71Salary, 101, 577
Sales
charge, 51
cost, 74
forecasts, 116–117
gains/loses, 308emanagement forecasts, 117
price, changes, 254

ratio. SeeNet working capital to sales
ratio
risk, 296, 577
economy, relationship, 297
volume, changes, 254
Salvage value, 76, 577
absence, 78
Samurai market, 26
Sarbanes-Oxley Act of 2002, 83, 104

600 INDEX
Savings deposit, 44–45, 577
Savings goal, meeting, 216, 229
Scheduled principal repayment,
231
Scientiﬁc calculators, usage, 206SEC. SeeSecurities and Exchange
Secondary market, 30–31, 578
classiﬁcation, 31
Securities
ﬁnance, 59, 578lending transaction, 59, 578markets, federal regulation, 25e
private placement, 58
traders/trading rules, 23trading, 58, 400

Securities Act of 1933, 30Securities and Exchange Commission
(SEC), 83
8-K ﬁlings, 193information gathering/publication
responsibility, 23
Rule 144A, 30
offerings, 58
10-K ﬁlings, 66, 82, 102, 193
10-Q ﬁlings, 66
Securities Exchange Act of 1934, 30Security, 578
Security market line (SML), 457–459,
578
expression, 458
Self-serving bias, cognitive bias, 441Selling group, 58, 578
Semiannual cash ﬂows, present value,
515

515
Semiannual yield, doubling, 525Semi-strong form. SeeMarket efﬁciency
Semivariance, 434–435, 578
variance, contrast, 435
Separately managed account, 49, 54,
578
Settlement date, 351, 578
alternative, 352
Settlement price, 353
Set-up expenditures, 304Share, 578
market price, 98
Shareholders, 93, 578
DRP beneﬁts, 136
equity, 72, 578
market value, 97–98
statement, 81
fee, 51share purchases, transaction costs
(absence), 136
wealth maximization

accounting irregularities,
relationship, 103–104
complication, 180social responsibility, 104
Shareholder value added (SVA), 120
Sharpe, William, 447, 456
Shirking, 100Short call position, 578
Short futures, 351, 578
Short position, 351Short put position, 578
Short selling, 361–362
Short selling, hedge fund strategy, 53Short-term assets, investment objective,
300
Short-term bank loans, 71
Short-term forward rates, behavior,
484

484
Short-term obligations, satisfaction,
247, 252
Short-term risk-free interest rate, 373,
374–375
Signaling explanation, 143, 145
Silo structure, 578Simple interest, 204, 578
Single-index performance evaluation
measures, 409–410
Single-period investment horizon, 450Single-period portfolio return, 419–420
Sirius XM Radio, convertible notes
issuance, 17
Small capitalization stocks, 396SML. SeeSecurity market line
SOA. SeeSociety of Actuaries

Index 601
Social responsibility, shareholder wealth
maximization (relationship), 104
Society of Actuaries (SOA), risk
management culture deﬁnition,
192
Sole proprietorship, 90–92, 578
characteristics, 91eprevalence, 96
Special dividends, 134
Spot market, 29, 578
Spread, 578
existence, 470–471
Spreadsheets, 516
program, usage, 334
usage, 228, 236
Standard and Poor’s 500 (S&P500)
index, 392

index, 392
Standard and Poor’s Corporation,
471
Standard deviation, 430e. See also
Stated conversion price, 578
Stated value, 578
State governments, issuer/investor role,
41–42
Statement of cash ﬂows. SeeCash ﬂow
Statement of shareholders’ equity. See
Shareholder
Statement of stockholders’ equity. See
Stockholder equity
Statements, relationship, 81–82Statistical estimate, error, 438Statistical factor model, 464–465
Stickney, Clyde, 292

Stock-based compensation, 82Stock distributions, 137–140
cash dividends, comparison, 138reasons, 138–140share price, 139
types, 137–138
Stock dividends, 578
accounting differences, 138–139example, 140
payment reason, 138
Stockholder equity, statement, 81Stocks
acquisition, 17appreciation right, 101, 578options, 76, 579
purchase right, 101–102
present value, 501–502repurchases, 147–150
methods, 147–148reasons, 148–150
returns, historical/cross-sectional
data, 464–465

shares, investor purchase, 98
Stock splits, 137, 579
accounting differences, 138–139example, 140stock dividend, comparison, 137
Straight-line depreciation, 76, 312, 579Straight value, 536, 579Strategic ERM risk objective, 190
Strategic plan, 110, 579
path, 110–111
Strategic risk management, 191Strategy, 110, 579
budgeting, relationship, 111e
company conceptualization, 112
dimensions, performance indicators,
124e
value
addition, 112–114

124e
value
creation, relationship, 124–128
relationship, 110–115
Strike price, 364, 372, 579
level, 372–373
Strong form. SeeMarket efﬁciency
Structure. SeeInterest rate
Structured ﬁnance, 197, 578Structured portfolio strategies, 400
Structured settlements, 47Style box, 578
Subperiod return, 403
average, calculation methodologies,
403–404
Subsidiary, ownership interest, 73
Sum-of-year’s digits method, 76, 579Sunk cost, 305

602 INDEX
Sun Microsystems, forward/reverse
stock splits, 140e
Sunoco Logistics Partners, master
limited partnership, 95
Supranational, 579
institution, 60
Sustainability, concept, 189
Sustainability risk, 186–188, 579
SVA. SeeShareholder value added
Swap curve, 579
Swap rate, 579
yield curve, 486–487, 579
Swaps, 376–379, 579
derivative contract, 350
types, 376

types, 376
Syndicated bank loan, 28, 579
Systematic risk, 456–457, 579
examples, 456
factors, 447, 579
systemic risk, contrast, 447
Tactical asset allocation, 393–394, 579Taft-Hartley plan, 54, 579
Tangible assets, 14, 580Targeted block repurchase, 147, 148
Target rate of return, 437
Taxes
change, 311–313considerations, 399credit, 304
ﬁnancial distress costs, trade-off, 176
usage, example, 164
Tax-free income, 148–149
Tax-preference calculation, 142,
144–145

144–145
Tax shield. SeeInterest
T-bills. SeeTreasury bills
10-K ﬁlings, 66, 82, 10210-Q ﬁlings, 66
Tender offer, 147–148, 580Tennessee Valley Authority (TVA),
government-owned corporation,39
Terminal price, 497
Terminal value, usage, 338–339Term structure, shape determinants,
481–482
Theoretical futures price, 360–362
Three-cash-ﬂow ordinary annuity,
present value (determination),229
Three-stage DDM, 500–501, 580
Time deposit, 44–45, 580

Time premium, 371–372, 580Times interest-covered ratio, 260
Time value. SeeOption
Time-weighted average quarterly
Time-weighted rate of return, 403–406,
580
example, 405result, 407
Tokyo Disneyland, catastrophe-linked
Tootsie Roll Industries, dividend
payments, 141
Total asset turnover, 580
calculation, 257
Toyota Motor Credit Corp., motor
vehicle value decline, 197
Trademarks, intangible asset, 70
Trade-off theory, 173–174

Trading at a discount, 51
Trading at a premium, 51Traditional asset classes, 395e, 397
Traditional ﬁnancial theory, 439
Transaction costs, 361
avoidance, 366
impact, 401
reduction, 17
Transactions
historical cost level recording,
assumption, 66
level, increase, 314–315
Treasury bills (T-bills), 26–27, 395, 580Treasury securities, 580Treasury spot rates, 477, 580
Treasury stock, 580
Treasury yield curve, role, 476–477Treynor, Jack, 447
True return, 208

Index 603
Truth in Savings Act of 1991, 233–234
Turnover ratio, 244
indication, 257
TVA. SeeTennessee Valley Authority
Tversky, Amos, 438–439
Two-asset portfolio, 427–428
example, 427
portfolio risk, measurement, 424
variance formula, 454
Two for one stock split, 137, 139
Two-parameter model, 422–423,
580
Two-year investment horizon,
478–479
Tyco, scandal, 185

478–479
UIT. SeeUnit investment trust
Unattractive provisions, inclusion,
473–474
Uncertainty, degree, 323, 326
Underlying
expected volatility, 373
market price, 373
term, usage, 29, 350, 580
Underlying asset, 29, 350, 580
Underwriting, 30
arrangements, types, 57function, 57
syndicate, 57–58, 580
Uneven cash ﬂows, 218e
Unfunded retained risk, 194, 580
United Kingdom, Financial Services
Authority, 53
accounting, contrast, 83–84corporations

dividend payments, 141foreign corporation joint ventures,
96
ﬁnancial system, map, 38eGDP, 38egovernment debt, 40e
government-sponsored enterprise,
examples, 41e
securities markets, federal regulation,
25eUnited States Postal Service (USPS),
39–40
Unit investment trust (UIT), 49, 51,
580
Unknown interest rate, determination,
216–217
Unsystematic risk, 456–457
examples, 456factors, 447, 580

Unvalued contract, 195, 580Upward-sloping yield curve, 481–482,
485, 580
Useful life, 580USPS. SeeUnited States Postal Service
Utility curves, CAPM (relationship),
453e
Utility function, 416–418, 580
illustration, 418e
Valuation, fundamental principle, 4ValuBond, 472
Value
creation, 114
sources, 126–128strategy, relationship, 124–128
strategy, relationship, 110–115
Value at risk (VaR), 436, 580. See also
Conditional value at risk
advantages, 436

Valued contract, 195, 581. See also
Unvalued contract
Value-oriented investment manager,
396
VaR. SeeValue at risk
Variance. SeeRandom variable
semivariance, contrast, 435
Variation margin, 353, 581
Vertical common-size analysis, 581
example, 267e
Vertical common-size balance sheets,
268e
Vivendi Universal, earthquake damage
protection, 197

604 INDEX
Wachovia Securities, 56
Wages payable, 71
Wal-Mart Stores, Inc.
comparative advantage, 111
dividends, 135e
Walt Disney Company, bonds issuance,
16
Weak form. SeeMarket efﬁciency
Wealth management, 6, 581
Working capital, 247, 581. See also Net
working capital
accounts, changes, 80, 82change, 314–320
classiﬁcation, 316
concept, 279decisions, 115
World Bank, 60WorldCom

expenses accounting, absence,
103
Xerox, earnings restatement, 103
Yankee market, 581
example, 26
Yield. SeeCapital; Equivalent taxable
yield
calculation, 232–233, 528
example, 236–237
compounding, 525coupon rate/price, relationship,
519–520
estimate, 514
example, 527
interest rate, relationship, 232–238
investment return, 235measure, 475, 524–532
ratio. SeeMuni-Treasury yield ratio
Yield curve, 221, 581

examples, 483eobservation, 482e
observed shapes, 477espread, 581
Yield to call (YTC), 528–529Y i e l dt oﬁ r s tc a l l ,5 2 8Yield-to-ﬁrst call, 581
Yield to maturity (YTM), 525–527, 581
calculation, 525
current yield, relationship, 526e
reinvestment risk, relationship,
530–532
Y i e l dt op a rc a l l ,5 2 8Yield-to-par call, 581
Yield to worst, 529, 581
Zero-coupon bond, 517, 581
package, 522–523
valuation, 517
Zero-coupon security, issuance, 477

Zero-coupon Treasury security,
purchase, 478

APPENDIX
Solutions to End of
Chapter Questions
CHAPTER 1
1.Financial management is the management of resources of a business en-
tity, whereas investment management is the management of investmentsin a portfolio that is managed for an individual, an institution, or an
entity.
2.The discount rate is the interest rate that translates future cash ﬂows
from an investment into a value today.

3.The responsibilities include managing the portfolio to be consistent withthe beneﬁciary’s investment objectives, constraints, and tax situation,
while also considering legal constraints.
4.Capital budgeting is decision-making pertaining to long term invest-
ments, whereas capital structure is the mix of long-term sources of
funding.
5.Current assets are assets of an entity that can reasonably be converted

to cash within one operating cycle or one year, whichever is longer.
6.
a.No. An investor cannot consistently earn abnormal proﬁts in anefﬁcient market.
b.If a market is efﬁcient, passive portfolio management is best.
7.The ﬁnancing decision involves determining the form of the ﬁnancing(debt or stock), the tenor (that is, the maturity) of the obligations the
company wishes to take on, and the terms (e.g., the interest rate on the
debt or the number of shares of stock).

8.Identify risk, assess it, and attempt to mitigate it and/or transfer it.
9.Enterprise risk management is the management of the risks for an entityas a whole.
10.Set objectives, establish investment policy, select an investment strategy,select speciﬁc assets, measure performance.
The Basics of Finance by Pamela Peterson Drake and Frank J. Fabozzi 1

APPENDIX
CHAPTER 2
1.In the case of indebtedness, the borrower has a contractual commitment
to repay the amount borrowed and interest. Equity is an ownershipinterest and the expectation of a return on the investment is in the form
of dividends and any price appreciation.
2.Preferred stock is equity, but it is a ﬁxed income security. Preferred stock
may or may not have a ﬁxed term.

3.Mutual funds take funds from investors and then invest these funds ina group of investments.
4.Maturity intermediation is the conversion of assets or securities withshort-term maturities into assets or securities with longer-term maturi-ties, or vice versa.
5.The Securities and Exchange Commission (SEC), Commodity Fu-tures Trading Commission (CFTC), and Financial Industry RegulatoryAuthority (FINRA).

6.Examples: Commercial paper, Treasury bills, negotiable certiﬁcates ofdeposit, bankers’ acceptance, repurchase agreements.
7.An exchange has a physical presence, whereas an over-the-counter
market is a network of dealer or market makers.
8.Weak form (prices reﬂect past price information), semi-strong form
(prices reﬂect public information), and strong form (prices reﬂect public
and private information).
9.In a primary market, the issuer obtains funds from investors; in the

secondary market, the issuer of the security is not involved in the trans-
action.
10.A spot market is a cash market, for an exchange today. A derivativesmarket involves trading in securities whose value depends on some as-
set’s value of cash ﬂows.

2 APPENDIX: SOLUTIONS TO END OF CHAPTER QUESTIONS
11.The money market is the market for securities with a maturity of one
year or less. The capital market is the market for securities with matu-
rities of greater than one year and for securities with no maturity (that
is, perpetual securities, such as common stock).
12.An investor’s strategy is affected by the degree of efﬁciency in the market
because this dictates what is impounded in a security’s price. If the

market is only weak form efﬁcient, then trading on the basic of publicly
available information could generate abnormal proﬁts; but if the marketis semi-strong efﬁcient, there would be no incentive to trade on publicly
available information.
13.
a.Information is asymmetric if there some market participants havemore information than others that is relevant to the valuation of an
asset.
b.If market participants believe that some other participants have an

unfair advantage in terms of relevant information, they may not
trade, resulting in less liquidity in the market.
c.As intermediaries, banks have served a role of providing information
to market participants.
d.Price discovery is the process of determining the value of an assetthrough the trading among buyers and sellers.
e.Without the ﬂow of information relevant to value an asset, there may
not be ready buyers and sellers and, hence, trading leading to price
discovery.
14.

14.
a.The information costs of ﬁnancial assets are the costs of securinginformation necessary for the valuation of the assets.
b.A market is liquid if there are buyers and sellers ready to trade an
asset.
c.Innovative products may involve complexities that are difﬁcult tounderstand and may impose more information costs to properly valuethe products.
15.
a.Standardization reduces the complexity of the various ﬁnancial as-sets, and hence reduces information costs.

b.Lowering information costs results in more participation by buyersand sellers, and hence more price discovery and liquidity.
The Basics of Finance by Pamela Peterson Drake and Frank J. Fabozzi

APPENDIX
CHAPTER 3
1.The federal government, the state and local governments, government-
sponsored enterprises, and government-owned corporations.
2.Government-owned corporations do not have publicly-traded stock and
are operated as not-for-proﬁt entities. GSEs are owned by shareholders
and operate for a proﬁt.
3.Both lend funds to individuals and businesses, but nondepository insti-
tutions do not accept deposits, whereas depository institutions do accept

deposits.
4.Required reserves are the minimum reserves required to be held bybanks, whereas excess reserves are the amount by which actual reservesexceed required reserves.
5.Life insurance, health insurance, property-casualty insurance, liabil-ity insurance, disability insurance, long-term care insurance, struc-tured sellements, investment-oriented products, and ﬁnancial guarantee
insurance.
6.A mutual fund will accept additional funds for investment, whereas a
closed-end fund does not.

7.Net asset value =($1−0.2)÷0.5=$1.60.
8.Can trade throughout the trading day, prices have only small deviationsfrom net asset value, and tax advantages.
9.In a deﬁned beneﬁt plan, the plan sponsor commits to a speciﬁc amountof beneﬁt upon retirement. In a deﬁned contribution plan, the plansponsor commits to a speciﬁc contribution to the employee’s retirement
plan, but not to a speciﬁc beneﬁt amount upon retirement.

10.Assist companies in raising funds, trading securities, advising in mergersand acquisitions (among other transactions), merchant banking, and
providing brokerage services.

11.Depository institutions: commercial banks, savings and loan associa-
tions, savings banks, and credit unions.
12.Commercial banks obtain most of their funds by borrowing, includ-ing accepting deposits (e.g., checking accounts, savings accounts, time
deposits, and money market accounts). These banks also obtain fundsby issuing securities (debt and equity), and borrowing from the Federal
Reserve.

Reserve.
13.Financial restructuring advising is guidance to company on its ﬁnancing
and capital structure, its operating structure, or its strategy. This ad-
vising may seek to simply improve the company’s operations or, in the
extreme, to forestall a bankruptcy.
14.
a.Global banking is the area of ﬁnance that involves ﬁnancing of en-tities, restructuring, and mergers and acquisitions. This is an area inwhich commercial banks and investment banks compete.

b.Global wealth and investment management involves investment poli-cies, investment strategies, selection of investments, and evaluatinginvestments’ performance.
15.Proprietary trading is trading for a company’s own account. Financialintermediaries may generate income from commissions when they facil-
itate trades, but in proprietary trading these institutions do not generate

commission income, but rather are investing on their own account inthe expectation of generating gain (though losses are also possible).
16.
a.Merchant banking is the investment by a ﬁnancial institution in com-panies, typically involving an equity interest.
b.The risks of merchant banking include the risk of loss of value, thedifﬁculty in valuing investments (especially those of privately-heldinvestments), and the lack of liquidity associated with some types of
merchant banking activity.

APPENDIX
CHAPTER 4
1.Assets =Liabilities +Equity.
2.(1) transactions are recorded at historical cost; (2) the dollar is the ap-
propriate unit of measure; (3) statements are prepared using the accrual
basis and the matching principle; (4) the business will continue as a
going concern; (5) there is full disclosure; and (6) the statements are
prepared on the basis of conservatism.
3.Cash, marketable securities inventory, and accounts receivable.

4.The length of time it takes for an investment in inventory to return cashin the form of accounts collected from customers.
5.Accounts payable, wages payable, current portion of long-term debt,
and short-term bank loans.
6.In the balance sheet, retained earnings are the accumulation of earningsthat have not been paid out in the form of dividends to owners. Inconnection to the income statement, retained earnings are earnings, less

7.Neither. The minority interest is the equity in a company that represents
the portion of the company not owned by the parent company. For
reporting purposes, the minority interest appears in shareholders’ equity.
8.Basic EPS is net income to common shareholders, divided by the average
shares outstanding. Diluted EPS is net income to common shareholders,
adjusted, dividend by the potential shares outstanding considering stock

options and other dilutions, for example, from convertible shares.
9.Under MACRS, the tax liability is less than that reported in the ﬁnancialstatements, so the deferred tax liability represents the tax obligation inthe future, which will be paid as MACRS depreciation becomes less
than straight-line.

10.The sum is the change in the balance of cash from the previous ﬁscal
period to the current ﬁscal period.
11.Historical costs are the actual expenditures made for an asset. For exam-ple, a building’s value on the balance sheet in gross plant and equipment
is its cost at the time of the company bought it or built it. Depreciationon the building is based on the original cost, so that the building’s value

in net plant and equipment reﬂects its original cost, less depreciation.
12.The footnotes that accompany the ﬁnancial statements provide more
information on deferred taxes. The footnote that is often entitled
“Income taxes” provides information about the company’s tax liability,
tax expense, and, if relevant, deferred taxes.
13.All in millions
a.Current assets =$6,076 +25,371 +11,192 +717+2,213 +3,711
=$49,280
b.Total assets =$49,280 +7,535 +4,933 +12,503 +1,759 +
279+1,599 =$77,888

c.Total liabilities =$3,324 +2,000 +3,156 +725+13,003 +
1,684 +3,142 +3,746 +1,281 +6,269 =$38,330
d.Stockholders’ equity =$62,382 −22,824 =$39,558
e.Total liabilities, plus stockholders’ equity =$38,330 +39,558 =
$77,888
Note:Assets =Liabilities +Stockholders’ equity
$77,888 =$38,330 +39,558
14.
a.Both Basic EPS and Diluted EPS are presented to provide information
to investors regarding the earnings per share given the current shares

outstanding (Basic EPS), and the earnings per share that would be ifall potential shares (e.g., from exercise of executive stock options, any
warrant exercise, and any convertible debt conversion) were issued
(Diluted EPS). Diluted EPS is a “worst case scenario” EPS in termsof possible dilution from additional issuance of shares.

b.Basic EPS means the earnings per share based on the current sharesoutstanding (using a weighted average of shares outstanding duringthe period the earnings were earned.
c.Diluted EPS means the earnings per share based on the potentialshares outstanding given all possible dilutions.
d.The closeness of Basic EPS and Diluted EPS indicates that there is
little potential for dilution.

Appendix: Solutions to End of Chapter Questions 3
15.
a.The Financial Accounting Standards Board (FASB) is the standard-
setting body for U.S. accounting.
b.The International Financial Reporting Standards (IFRS) are the ac-
counting standards accepted in many countries outside the U.S. These
standards are promulgated by the International Accounting Stan-
dards Board (IASB). Eventually, the U.S. GAAP and IFRS will con-
verge to one set of standards.

c.Generally accepted accounting principles (GAAP) are a set of stan-
dards that are the accepted standards for accounting. U.S. GAAP is
the set of standards promulgated by the Financial Accounting Stan-dards Board (FASB).

APPENDIX
CHAPTER 5
1.Two primary differences: (1) A partnership is taxed only at the partner
level, whereas the corporation is taxed at the corporate and shareholderlevels; (2) A partnership has more limited access to funds than a corpo-
ration.
2.Limited liability is the legal situation in which the owners of a company
are not liable for all of the debts of the business. In the case of a cor-

poration or an LLC, which both have limited liability, the most owners
can lose is their investment in the business.
3.(1) At the corporate level, and (2) At the shareholder level on distributedincome in the form of cash dividends.
4.A corporation and an LLC may have perpetual lives.
5.Agency costs of costs borne by the agent, the principal, or both. Forexample, in the agency relationship in a corporation, the principals(the shareholders) bear the cost of excessive perquisite consumption by

management.
6.The objective is to maximize the value of the shareholders’ interest in
7.Salary, bonus, options, performance shares.
8.Options are intended to encourage managers to be concerned about thevalue of the stock of the company because the greater the value of the
stock, the greater the value of the executive stock options.
9.This provision represents the bonding costs; the manager bears a cost
in terms of future beneﬁt from working for the company’s competitors

following employment by the company.
10.If earnings are understated in one period, they are likely overstated.By moving expenses sooner, for example, the expenses in the following
period(s) are less and, hence, earnings are more.

11.A company’s market capitalization is the market value of its stock. This
is the product of the current market price per share and the number of
shares of stock outstanding.
12.
a.With a C corporation, income is taxed at the corporate level (withthe company’s ﬁling of its tax Form 1020), and then once again
when it is distributed to shareholders in the form of dividends (if the

shareholders are individuals, then the dividend income is reported onthe individuals’ tax Form 1040).
b.The advantages are primarily the single level of taxation and thelimited liability.
13.
a.Agency costs are costs (explicit or implicit) that arise when theparties—the agent acting in the interests of the principal, and theprincipal—diverge.

b.Principals can reduce agency costs by “bonding”; that is, makingcommitments that would be costly if interests diverge (e.g., anon-compete clause if the manager leaves the employment of the
company).
14.
a.Limited liability is the limit on the ﬁnancial responsibility of a party
to the obligations of an entity.
b.Agree: The limited liability imposes a burden on the creditors because
they may not receive the full amount that they are due if the fund

is bankrupt. Disagree: Though the limited liability imposes a bur-den, the additional risk provides a potential for additional rewards,
which would in that case offer more protection of the interests of the
creditors.
c.The seeking of short-term gains at the expense of long-term value
and risks would be a form of agency costs. The motives of a fund
manager to be “competitive” and perhaps even affect short-termcompensation are self-serving motives.

d.Stakeholders are any party affected by the actions of another. In thecase of the management of funds, the stakeholders include not onlythe fund beneﬁciaries, but any party that becomes obligated to make
up short-falls, anyone employed by the charity that may lose their
job, anyone whose services are curtailed because of a lack of funds.

APPENDIX
CHAPTER 6
1.A strategy is the general direction a company takes for reaching an
2.Comparative advantages relate to cost structure and product differenti-
ation, whereas competitive advantages relate to market structure.
3.A strategic plan is the speciﬁc actions or roadmap a company intends totake to reach an objective.
4.A ﬁnancial plan relates to the allocation of company resources and a plan

of how the company will ﬁnance its investment decisions. A ﬁnancial
plan is one component in a company’s strategic plan.
5.Regression analysis is a statistical approach to estimating the histori-
cal relation between two or more factors. It is useful to gauge general
relationships that existed in the past, and is useful, to some extent, in
forecasting.
6.A pro forma ﬁnancial statement is a projected ﬁnancial statement, based
on sales and cash forecasting.

7.Economic value added is economic proﬁt. Financial managers, who seek
to maximize shareholder wealth, are interested in making decisions that
enhance the value of the ﬁrm, and hence add economic value.
8.A balanced scorecard is a set of measures used to evaluate different
aspects of a company’s performance.
9.Signiﬁcant proﬁts and low barriers of entry will attract entrants. Interms of Porter’s forces, the threat of entrants is high and, hence, there

is signiﬁcant rivalry.
10.Economic proﬁts arise from a comparative or competitive advantage.

11.
a.A strategic plan is designed to guide the company towards its objec-
tives, assisting management in both the operational and the ﬁnancialdecision-making in a business entity.
b.The strategic plan is useful in guiding decision-making, but condi-tions change, requiring adjustments in this plan. Financial decision-
making is dynamic, and strategic plans must evolve through time.
12.

12.
a.Strategic planning is a plan to achieve a company’s objectives. Finan-cial planning is a component of strategic planning, used in conjunc-
tion with budgets and performance metrics.
b.Financial planning involves budgeting (including sales projections
and projections of ﬁnancing needs) and performance measurement.
c.Operational planning is the budgeting and evaluation of day-to-day
operations, including a focus on management of operating expenses

and short-term ﬁnancing needs to support operations.
d.Capital allocation refers to the long-term investment of a company
in plant, property, and equipment.
e.Agree: A ﬁnancial plan is not meaningful without a strategy becauseyou do not know the targets that help guide the decision-making.
13.
a.EVA is economic value added, a measure of economic proﬁt thatconsiders not only revenues and expenditures, but also the cost of
capital. Economic value added is calculated as revenues, less expen-

ditures and taxes on a cash basis, less the dollar value of the cost ofcapital.
b.EVA is a branded version of the economic construct of proﬁt.
14.
a.The balanced scorecard provides multiple dimensions for evaluating
b.The four new processes are: (1) understanding the strategy, (2) com-
municating and linking measures to the company’s strategy, (3) plan-
ning, budgeting and target setting, and (4) providing feedback on

APPENDIX
CHAPTER 7
1.The dividend payout ratio is the proportion of earnings paid to share-
holders in the form of cash dividends. The dividend per share is the
amount of dividend paid per share.
2.The retention rate =1−0.80=20%.
3.Dividend payout ratio =$2÷$8=25%.
4.Low or no transactions costs.
5.Technically, the difference is the accounting entry (shift from retainedearnings to paid-in capital for a stock dividend, a memo entry for a stock

split). Practically, the size: a stock split is generally used more often for
larger distributions, a stock dividend for smaller distributions.
6.A reverse stock split is intended to increase the share price, possibly
forestalling delisting from an exchange.
7.A stock split is expected to reduce a share price to a proportion of the
predistribution price; a 2:1 should reduce the price to one-half, a 4:1
should reduce the price to 1/4, etc.

8.(1) Signal the future prospects of the company without a cash outlay;
and (2) Reduce the price per share.
9.(1) Investors’ preference for a stream of certain cash ﬂows; (2) Signalfuture prospects of the company; (3) Force the company to seek externalfunds, resulting in increased monitoring of the company.
10.Tender offer & Dutch tender offer; open market repurchase; targetedblock repurchase.

11.
StockExpected price per share
after distributionNumber of shares outstanding
after the distribution
ABC $20 ÷2=$10 1 million ×2=2 million
DEF $40 ×5=$200 0.5 million ÷5=0.1 million
GHI $25 ×2.5=$62.50 2 million ×2.5=5 million
12.Dividends =$50 million; Net income =$200 million; Shares outstand-
ing=3 million
a.Dividend payout ratio =$50 million ÷$200 million =25%
b.Dividend per share =$50 million ÷3 million =$16.67 per share

13.Retention ratio =1−($2÷$5)=1−0.4=0.6 or 60%
14.Growing the dividend over time, when the dividend is based on a rel-
atively ﬁxed dividend payout, can be interpreted as the company’s ex-
pectation that earnings from continuing operations (that is, before ex-traordinary and special items) will grow.
15.
a.(1) A bird-in-the hand—that is, a dividend paid—is worth more thanthe expectation of an increasing share price. (2) A company paying

dividends may be signaling that they are able to sustain the increased
dividend payout in the future, and hence are signaling positive ex-pectations about future earnings. (3) The payment of dividends uses
funds that could be invested in long-term capital projects, which then
forces the company to borrow—hence increasing the monitoring of
the company by creditors and investors.
b.Paying dividends affects only the ﬁnancing decision, and companies

paying dividends will simply need to borrow to fund proﬁtable in-
vestment projects. Because the value of a company is the present
value of all future cash ﬂows that it generates, the value of the com-pany is affected by the return on its capital projects, not how these
projects are ﬁnanced.
c.Because dividends are typically taxed at rates higher than capital
gains, shareholders who pay taxes should prefer to receive a return
on their stock in the form of share appreciation, rather than through

d.A perfect capital market is one in which there are no taxes, no trans-
actions costs, no costs for information, and no ﬂotation costs when
issuing securities.
e.The assumed investment policy is one in which the company invests
in all proﬁtable projects.
f.Managers are perfect agents of shareholders if they act in sharehold-ers’ best interests, rather than their own. In other words, there are
no agency costs.

APPENDIX
CHAPTER 8
1.Financial leverage increases the sensitivity of the returns to equity to
changes in operating earnings. The greater the ﬁnancial leverage, thegreater the return on equity for earnings beyond break-even, and the
lower the return on equity for earnings below break-even earnings.
2.The interest tax shield is the amount of taxes that interest shields from
taxation because of the deductibility of interest in determining taxable
income.

income.
3.If the marginal tax rate increases, the interest tax shield increases—andhence, the value of this tax shield to owners.
4.A 2% increase in operating earnings will result in a 2% ×2=4%
increase in earnings to owners.
5.Debt ﬁnancing (1) reduces the funds available that may be wasted, and
(2) provides additional monitoring from the market (evaluating a debtissue).
6.Because owners reap the beneﬁts of gains, but do not share fully in thelosses, limited liability encourages risk taking.

7.Costs to ﬁnancial distress discourage debt ﬁnancing, counterbalancing
the beneﬁt from interest deductibility at some point.
8.Interest on debt is tax deductible for the paying company, whereas
dividends paid are not tax deductible.
9.The trade-off is between the beneﬁt from interest deductibility and costsof ﬁnancial distress.
10.The greater a company’s operating risk, the sooner the company reaches
an optimal capital structure in terms of the proportion of debt used to
ﬁnance the company.

11.The pecking order theory of capital structure is the theory that statesthat companies have preference in the capital that they raise, with the

preference order of internal equity (that is, retained earnings), debt, and
then new equity.
12.When there are taxes, the Modigliani-Miller theory implies that theoptimal capital structure is the one with as much debt as possible—as
long as there are no costs associated with ﬁnancial distress.
13.
a.Alternative C involves the greatest ﬁnancial leverage.
b.Alternative A involves the least ﬁnancial leverage.

14.Costs associated with ﬁnancial distress include direct costs, such as legal
fees or consulting fees, and indirect costs, including foregone proﬁtable
opportunities, a loss of market share or competitive advantage, and theinability to secure long-term contracts.
15.Costs associated with bankruptcy include the direct costs, such as auditand legal fees, and indirect costs, including foregone proﬁtable oppor-tunities, the reduced value of intangibles because of an inability to fully

exploit these assets, a loss of market share or competitive advantage,
and the inability to secure long-term contracts.
16.
a.Financial slack is the unused debt capacity of a company.
b.Financial slack is created when the company intentionally manages
its ﬁnancing activity so that its capital structure is less than what the
company can handle.
c.Companies desire ﬁnancial slack because it gives them ﬂexibility, the
ability to engage in investment opportunities that may come along

for which ﬁnancing is needed to make the investment.

APPENDIX
CHAPTER 9
1.Core risks are the business or operating risk that relate to the company’s
line of business. Non-core risks are those that are incidental to thecompany’s line of business.
2.Portfolio theory focuses the attention on the risk of the whole, ratherthan on individual investments. Enterprise risk management focuses onthe risk of the whole as well.

3.Sustainability risk is a broad spectrum of the risk of a business enterprisethat includes social and environmental responsibilities.
4.Retain, neutralize, transfer.
5.A funded retained risk is one in which funds have been set aside tosatisfy the potential loss, whereas an unfunded retained risk is one in
which no provision has been made for the potential loss.
6.Insurance-linked notes and bonds transfer risk to the investor of the
security.

security.
7.Derivatives, insurance, structured ﬁnance, and alternative risk transfer(such as an insurance-linked note).
8.The core risk relates to a business’s main enterprise, where a noncore
risk is incidental to the business.
9.Derivatives can be used to transfer risk, such as using futures contracts
to transfer the risk of a commodity’s price to another party.
10.A cat bond, or catastrophe-linked bond, transfers the risk of the identi-ﬁed event from the business to investors.

11.Value stocks are generally viewed as those stocks that have market
values that currently reﬂect lower expectations regarding future growth
than other stocks in the market (and, hence, lower P/B ratios), and
therefore as the P/B returns to normal or typically market levels, the
price of the stock will rise.

12.
a.This statement leaves out an important consideration: the risk of the
portfolio (relative to that of the benchmark).
b.Further evaluation of the return difference is necessary to attribute
performance (e.g., to the style of selection).
c.Leverage can exaggerate returns—both up and down—and must beconsidered as part of the investment policy.
13.Constraints may be imposed regarding risk, the asset allocation, and the

cash ﬂows from the investments.
14.Return =($3,500 −3,000 +250)÷$3,000 =25%
15.Time-weighted return =[(1.05) (0.97)(1.04)(1.05)]
0.25=1.1122020.25
−1=2.6942%

APPENDIX
CHAPTER 10
1.The discounting is the reverse process of compounding. In compound-
ing, we seek the future value of a lump-sum, whereas in discounting weseek the present value of a lump-sum.
2.Larger.
3.Smaller.
4.Continuous compounding. The greater the frequency of compounding,
the greater the future value for a given annual percentage rate.

5.In an ordinary annuity, the ﬁrst cash ﬂow occurs one period from today(that is, end-of-period cash ﬂows). In an annuity due, the ﬁrst cash ﬂow
occurs today (that is, beginning-of-the-period cash ﬂows).
6.In an ordinary annuity, the ﬁrst cash ﬂow occurs one period from today
(that is, end-of-period cash ﬂows). In a deferred annuity, the ﬁrst cash
ﬂow occurs beyond one period from today.
7.This is a perpetuity. We calculate the present value by dividing the

periodic cash ﬂow by the discount rate.
8.The geometric average is most appropriate because it considers com-
pounding. The arithmetic average does not.
9.A deferred annuity can be solved by ﬁrst solving for the present valueof an ordinary annuity, and then discounting this the present. The dis-counting in the second step may be a lump-sum or an annuity, depending
on the nature of the problem.
10.The annuity due will have the higher present value, relative to the ordi-

nary annuity, because each cash ﬂow is received sooner than that of the
ordinary cash ﬂow.
11.In general, the investment with compound interest produces a greatervalue than the investment with the same interest rate but with simple
interest. The only exception is in the case of annual compounding and

you are comparing the value of a one-year investment; in this case, the
value would be the same.
12.
a.As long as interest is compounded no more than a single time, at the
end of the year, the EAR is equivalent to the APR.
b.EAR and APR diverge as the frequency of compounding increases.
The more frequent the compounding, the more EAR exceeds the
APR.
13.For compound interest, i =0.04÷4=0.01 or 1%; N =10×4=40

a.Balance in the account =FV=$1,000 (1 +0.04/4)40=$1,000 (1 +
0.01)40=$1,488.86.
b.Interest on interest =FVcompound −FVsimple
=$1,488.86 −[$1,000 +(10×0.04×$1,000)]
=$1,488.86 −1,400 =$88.86.
14.PV=$10,000 ÷(1+0.06)5=$10,000 ÷1.3382 =$10,000 ×
0.747258 =$7,472.58
15.PV=$10,000; i =3%÷12=0.0025 or 0.25%
a.N=24; PMT =$429.81 per month
b.N=36; PMT =$290.81 per month

APPENDIX
CHAPTER 11
1.Both the current ratio and the quick ratio are liquidity measures. The
quick ratio removes the least liquid current asset, inventory, from thenumerator of the current ratio, providing a more stringent liquidity
measure. Numerically, the current ratio is always greater than or equal
to the quick ratio at a given point in time.
2.The longer the cash conversion cycle, the greater a company’s need for

3.A cash conversion cycle may be negative if the company receives moregenerous credit terms from its suppliers than it provides its customers.
4.The inventory turnover, multiplied by the number of days in inventory,
is equal to the number of days in the period.
5.The total asset turnover must be 2.0, based on the Du Pont relationship:net proﬁt margin ×total asset turnover =return on assets.
6.If debt ÷assets =0.35, this means that equity is 65% of assets, or the

debt equity ratio is 0.35 ÷0.65=0.5385.
7.If the use of debt increases, vis- `a-vis equity, then equity multiplier in-
creases and the return on equity increases.
8.If the company does not have any debt, the return on assets is equal tothe return on debt.
9.The basic earning power allows you to compare companies without
regard to how they chose to ﬁnance their operations. This is useful

when comparing companies that operate in the same line of business, inwhich they should experience the same level of business risk.
10.If debt-to-assets is 50%, this means that the equity multiplier is 2 andtherefore the return on equity is 20%.
11.Because Company B’s quick ratio is greater than Company A’s, we canconclude that Company A has relatively more inventory than Company

B. We conclude this because the current ratios are the same, yet Com-
pany A’s quick ratio is less than Company’s B, which indicates that the
numerator of the quick ratio has a larger subtraction for inventory in
the case of Company A.
12.Company D has a longer operating cycle, and therefore most likely has
a greater need for liquidity than Company C. However, Company D
does not have more liquidity than Company C, and therefore has more

risk of not satisfying its near-term obligations.
13.A return on ﬁxed assets would be a ratio of net income or operating
income to ﬁxed assets. You could break this into two components, a
ﬁxed asset turnover and a proﬁt margin.
14.It would be useful to have information on the trend in the company’s
asset turnover, operating proﬁt margin, interest burden, and tax burden.

It would also be useful to see if the company’s lines of business changedover this period (for example, through acquisitions), that may suggest
changes in the company’s underlying fundamental relationships.
15.
a.Current ratio =$2,000 ÷$500 =4
b.Quick ratio =$1,000 ÷$500 =2
c.Inventory turnover ratio =$10,800 ÷$1,000 =10.8 times
d.Total asset turnover ratio =$12,000 ÷$6,000 =2t i m e s
e.Gross proﬁt margin =$1,200 ÷$12,000 =10%
f.Operating proﬁt margin =$1,050 ÷$12,000 =8.75%

g.Net proﬁt margin =$600 ÷$12,000 =5%
h.Debt-to-assets ratio =$1,000 ÷$6,000 =0.1667
i.Debt-to-equity ratio =$1,000 ÷$5,000 =0.2
j.Return on assets, basic earning power =$1,050 ÷$6,000 =17.5%
k.Return on equity =$600 ÷$5,000 =12%
16.Company Y has more leverage. Its equity multiplier (that is, total assetsdivided by shareholders’ equity) is 2.0, whereas Company X’s equity
multiplier is 1.5.
17.
Cash 13.89% Current liabilities 8.33%

17.
Accounts receivable 8.33% Long-term debt 25.00%
Inventory 22.22% Equity 66.67%
Plant & equipment 55.56%
Total assets 100.00% Total liabilities and equity 100.00%

APPENDIX
CHAPTER 12
1.Depreciation is not a a cash outﬂow, but rather is a noncash expense
that reduced net income. Therefore, depreciation is added back to netincome in the calculation of cash ﬂow.
2.The ﬁnancial statements prepared using accrual accounting reﬂects non-cash items in income, such as sales on credit. The adjustment for changes
in working capital account is done to convert net income based on
accrual accounting into cash ﬂow.

3.Net income is $3 million less $2 million, or $1 million.
4.The changes in working capital accounts are used in determining cashﬂow from operations. The sum of the cash ﬂows from operating, ﬁnanc-ing, and investment activities is the change in the cash account from one
year to the next.
5.Net income from the income statement is the starting point for the cash
ﬂow from operations statement of cash ﬂows.

6.Yes, if the depreciation expense, the amortization expense, or thechanges in working capital accounts are sufﬁciently large.
7.Two items: after-tax interest expense and capital expenditures.
8.EBITDA and cash ﬂow from operations differ due to the changes inworking capital accounts, interest expense, and taxes.
9.A negative free cash ﬂow indicates that there are no funds that can be
invested in value destroying investments.

10.A positive free cash ﬂow indicates that there are funds available thatcould be invested in value destroying investments.

11.FCFE =$100 million; FCFF =$125 million; Interest after tax =$10.
From the basic formulas for free cash ﬂow:
Deﬁnition 2: FCFF =CFO −adjusted interest −capital
Deﬁnition 3: FCFE =CFO−capital expenditures +borrowings −
debt repayments
Therefore, FCFE =FCFF −adjusted interest +borrowings −debt
$100 million =$125 million −10 million +borrowings −debt
Borrowings −debt repayments =−$15

or, in other words, net debt repayment of $15 million
12.Free cash ﬂow to equity (FCFE) =$200 million −50 million =$150
million
Free cash ﬂow to the ﬁrm (FCFF) =$200 million −50 million =
$150 million
13.CFO=Net income +depreciation −change in working capital.
$35 million =$30 million +$3 million −change in working capital
Change in working capital =−$2 million, which means that work-
ing capital investment declined during the period.

14.For ﬁscal year 20X2, Cash ﬂow =net income +depreciation and amor-
tization −increase in working capital =$290.
a.Cash ﬂow to capital expenditures =$290 ÷$100 =2.9
b.Using total liabilities as the measure of debt,Cash ﬂow to debt ratio =$290 ÷($130 +163)=$290 ÷$293 =
0.9898

APPENDIX
CHAPTER 13
1.By reducing expenses, it increases a company’s cash ﬂows. Reducing
expenses will increase taxes, but there will be a net beneﬁt from thereduction in expenditures.
2.The depreciation tax shield is the amount of taxes reduced by deductingdepreciation. The depreciation tax shield increases available cash ﬂow,
and hence makes the project more attractive.
3.If the facility had no other use, this would be a sunk cost and this cost

does not affect the investment decision. If the facility could have been
used (e.g., rented out), then this forgone rent should be considered in
the investment decision.
4.Mathematically, if the project has a positive net present value, it must
pay back in terms of undiscounted and discounted cash ﬂows.
5.The difference is a recapture of depreciation, and is taxed as ordinary
income.

income.
6.Straight-line depreciation will result in lower depreciation in the earlieryears, and hence lower depreciation tax shields, vis- `a-vis MACRS de-
preciation. The lower cash ﬂows earlier in the project’s life will reduce
its net present value.
7.In the case of mutually exclusive projects, the NPV and PI methods can
be used.
8.This means that the discount rate is less than the cross-over rate.
9.If there is a limit to the capital budget, the net present value method is
most appropriate.

10.The differing reinvestment assumptions: the NPV method assumes rein-
vestment at the cost of capital; the IRR method assumes reinvestment
at the IRR.

11.
Opening a retail outlet New market
Introducing a new line of dolls New product
Introducing a new action ﬁgure in an existing line of action ﬁgures New product
Adding pollution control equipment to avoid environmental ﬁnes Mandated
Computerizing the doll molding equipment Replacement
Introducing a child’s version of an existing adult board game New product
12.Expected sales of the new boots, as well as the potential loss of sales

from the existing line of boots.
13.The book value at the end of the 10th year is zero for both machines,so the sales price is equivalent to the gain.
Machine 1 Machine 2
a. Acquisition
Initial cost $100,000 $80,000
Set-up cost $20,000 $30,000
Total acquisition cash ﬂow −$120,000 −$110,000
b. Disposition
Cash from sale $20,000 $10,000
Tax on gain 7,000 3,500
Cash ﬂow from disposition $13,000 $6,500
14.See the table below for details.a.$40.2 million

b.$11.4 million, $13.320 million, and $12.456 million
c.$15.984 million
d.−$40.2 initially, and then $15.4 million, $20.52 million, and$42.632 million

Year
01 2 3
Initial cost −$40,000,000
Change in working
capital−200,000 $ 200,000
Sale price 25,000,000
T a xo ng a i no ns a l e −784,000
Investment cash
ﬂows−$40,200,000 $ 0 $ 0 $24,416,000
Change in revenues $20,000,000 $20,000,000 $20,000,000
Change in
operating costs5,000,000 5,000,000 5,000,000
Change in
depreciation4,000,000 7,200,000 5,760,000
Change in taxable
income$19,000,000 $22,200,000 $20,760,000

Change in taxes 7,600,000 8,880,000 8,304,000
Change in income
after taxes$11,400,000 $13,320,000 $12,456,000
Add: depreciation 4,000,000 7,200,000 5,760,000
Operating cash
ﬂows$15,400,000 $20,520,000 $18,216,000
Net cash ﬂows −$40,200,000 $15,400,000 $20,520,000 $42,632,000
Note:
Year
123
Book value of the jet, end of period $36,000,000 $28,800,000 $23,040,000
T a xo ng a i no ns a l e
Sales price $25,000,000
Book value 23,040,000
Gain $ 1,960,000

Tax on gain $ 784,000
15.This means that if you invest in the project, you expect to increase the
value of the company by $10 million.
16.This means that (1) the ratio of the present value of the cash inﬂows to
the present value of the cash outﬂows is 1.3, and (2) the project has a
positive net present value.

4 APPENDIX: SOLUTIONS TO END OF CHAPTER QUESTIONS
17.The proﬁtability index is ($30 +100)÷$100 =1.3
18.
a. Payback =3y e a r s
b. Discounted payback at 10% =4y e a r s
c. Discounted payback at 16% =Does not payback
d. Net present value at 10% =$10,945.29
e. Net present value at 16% =− $2,063.68
f. Proﬁtability index at 10% =1.11
g. Proﬁtability index at 16% =0.98
h. Internal rate of return =15%
i. Modiﬁed internal rate of return
with reinvestment at 0%
[Terminal value =
$140,000]=8.8%

j. Modiﬁed internal rate of return
with reinvestment at 10%
$162,435]=12.9%
19.
a.At a cost of capital of 5%, NPV Thing 1 =$1,677 and NPV Thing 2 =
$2,045. Prefer Thing 2.
b.At a cost of capital of 8%, NPV Thing 1 =$907 and NPV Thing 2 =
$762. Prefer Thing 1.
c.At a cost of capital of 11%, NPV Thing 1 =$216 and NPV Thing 2 =
−$356. Prefer Thing 1.
d.At a cost of capital of 14%, NPV Thing 1 =−$405 and NPV Thing 2 =
−$1,331. Reject both.

e.Cross-over discount rate is 7.09%

Appendix: Solutions to End of Chapter Questions 5
f.

APPENDIX
CHAPTER 14
1.In the cash and carry trade, the investor sells futures, buys the asset,
ﬁnancing it, and then delivers it at the end of the contract. In a reversecash and carry trade, the investor buys futures, sells the asset, and lends
the proceeds, taking delivery of the asset at the end of the contract.
2.The proﬁt is zero.

3.Futures and forwards are similar, but futures are standardized contractsand trading involves a clearinghouse, whereas forwards are not stan-
dardized and are traded over-the-counter, subject to counterparty risk.
4.The option is out-of-the-money because the underlying’s value is lessthan the exercise price.
5.The payoff is −$5.

6.The greater the time to expiration, the greater the call and the putoption—because there is more time remaining for the option to becomevaluable.
7.The more volatility of the underlying’s value, the more valuable boththe call and the put option.
8.You could buy a put option or you could sell a call option.
9.You could buy a call option or you could sell a put option.
10.Interest rate swap.
11.In the case of derivatives, there is some underlying that is involved in

a potential transaction in the future. For example, in the case of an
interest rate swap, there is a future exchange of the net cash ﬂows ateach agreed-upon future date. There is risk that one of the parties—the
other party, the counterparty—will not comply with the agree-upon
exchange at one of the future dates.
12.The manufacturer could enter into a futures contract now to lock in theprice of the lumber three months from now. The manufacturer would

be the buyer, with a commitment to take delivery of the lumber at a
future point at time at a speciﬁed price.
13.
a.Forward contracts do have the advantage that they can be cus-
tomized, but unlike futures contracts, there is counterparty risk—therisk that the other party to the transaction does not carry out their
obligations under the contract.
b.A factor to consider is that by tailoring it to the corporation’s needs,

there must be another party willing to take the other side of the
transaction, as tailored as it is.
14.A put option is an option to sell the underlying. A call option is an
option to buy the underlying.
15.An American option may be exercised at any time prior to the expirationdate. A European option may be exercised only at the expiration date.
16.Disagree. In the case of an option, the buyer of the option has a choice
whether to exercise the option. In the case of futures, the buyer is com-

mitted to a transaction unless an offsetting transaction is made.
17.
a.A call option: an option to buy the underlying at a speciﬁed price.
b.A put option: an option to sell the underlying at a speciﬁed price.
18.The payoff (that is, proﬁt) for a call option is the price of the underlying−exercise price −option premium; the greater the option premium,
the more that the underlying’s price must exceed the exercise price for

a proﬁt. The payoff (that is, proﬁt) for a put option is the price exercise
price−price of the underlying −option premium; the greater the option
premium, the more that the price of the underlying must be less than
the price of the underlying to be proﬁtable.
19.
a.intrinsic value =$42−40=$2; time value =$5−2=$3
b.intrinsic value =$40−50=−$10→$0; time value =$5−0=$5
20.
a.Interest rate swap
b.Orono pays 7% ×$75 million =$5,250,000; Portland pays 4% ×

$75 million =$3,000,000. The net payment (Orono to Portland) is
$2,250,000, or 3% of $75 million.

APPENDIX
CHAPTER 15
1.Equity; Bonds; Real estate; cash equivalents.
2.Policy asset allocation focuses on the long-term objective, seeking the
greatest return for the level of risk consistent with the investment objec-
tive. The dynamic asset allocation is the adjustment of the asset mix of
a portfolio in response to anticipated market conditions.
3.Market cap is market capitalization, the market value of equity out-

standing of a corporation. Some advocate that the returns to stocks of
companies with small versus large capitalization are different, and select
common stocks appropriate with this belief.
4.An active portfolio strategy involves changing the investments in the
portfolio to seek better portfolio returns. A passive portfolio strategy
focuses on the initial construction of the portfolio, rather than altering

investments. A passive portfolio is consistent with the belief that themarkets are efﬁcient, whereas an active portfolio strategy seeks abnor-
mal returns that arise from pricing inefﬁciencies.
5.A price-efﬁcient market is one in which the current prices of assets reﬂect
all publicly available information.
6.The arithmetic average return ignores compounding of returns from onesubperiod to the next.
7.The time-weighted return is better for evaluating a portfolio manager

because it is not affected by the contributions and withdrawals of the
fund.
8.R
TW=(0.95 ×1.1×1.1)1/3−1=4.754%.
9.PV=$1; FV =$1×0.95×1.1×1.1=$1.1495; N =3; IRR =4.754%.
10.The purpose of performance attribution models is to assess the per-
formance of an investment or fund associated with the selection of
investments and the allocation among investments.

11.
a.Structured insurance is a form of risk transfer that combines tradi-
tional insurance with securities, in which investors in the securitiesbear some of the risk.
b.Another name for structured insurance is “insurance-linked securi-ties”.
c.An example of structured insurance is the catastrophe-linked bond(or “cat bond”).

APPENDIX
CHAPTER 16
1.A utility function is a theoretical description of the tradeoff an individual
economic agent has between return and risk.
2.If the correlation is positive, the covariance between the two assets’
returns is also positive.
3.Diversiﬁcation is achieved by combining investments whose returns arenot perfectly positively correlated. Greater diversiﬁcation is achieved the
lower the correlation.

4.The efﬁcient portfolio is one of the feasible portfolios. It is the feasible
portfolio with the highest return for a given level of risk.
5.The semivariance provides information on the dispersion below the
mean or expected value, whereas the variance provides information on
the dispersion above and below the mean.
6.A safety-ﬁrst rule is a decision rule that minimizes the probability of
falling below a speciﬁed value.

7.Prospect theory is a theory of individuals’ behavior such that decision-making depends on how a problem is framed, that the focus is on howvalues change, rather than the values themselves, and that the decision
weight given to gains is different than that given to losses.
8.Framing is the situation. Some behavioral theories argue that investors
are inﬂuenced by the situation or how an investment is presented, rather

than simply on an investment’s expected return and variance.
9.Classical safety-ﬁrst, value at risk, conditional value at risk, lower partialmoment.
10.A cognitive bias is a bias in decision-making that results from errors in
judgment. These errors include framing and overconﬁdence.

11.
a.If the covariance is negative, the correlation is negative.
b.The portfolio’s risk will be less than the weighted average of the risks
of Asset A and Asset B.
12.
a.B: same return, lower risk
b.C: same return, lower risk
c.C: higher return, lower risk
13.
a.Expected return is 5%
b.Standard deviation is 12.247%
Scenario ProbabilityPossible
outcomeProbability
weighted
outcomeDeviation
from the
expected
valueSquared

from the
expected
deviationProbability
weighted
squared
deviation
Recovers 40% 0.20000 0.08000 0.15000 0.02250 0.00900
Does not
recover60% −0.05000 −0.03000 −0.10000 0.01000 0.00600
Expected value = 0.05000 0.05000 Variance =0.01500
Standard deviation =0.12247
14.
a.Expected value =0%
b.Standard deviation =15%
weighted
from the
expected
weighted
squared

weighted
squared
deviation
Recovers 50% 0.15000 0.07500 0.15000 0.02250 0.01125
Does
notrecover50% −0.15000 −0.07500
−0.15000 0.02250 0.01125
Expected value = 0.00000 Variance =0.02250
Standard deviation =0.15000
15.Altering the weights of the securities will change the portfolio risk,
similar to Exhibit 16.5, because the weights of the two securities are
used in calculation of the variance of the portfolio [see Equation 16.6].

APPENDIX
CHAPTER 17
1.Diversiﬁable risk is the risk that an investor can reduce or eliminate by
combining assets in a portfolio such that these assets’ returns are notperfectly positively correlated among themselves.
2.In the CAPM, we assume that investors will seek the most return forthese least amount of risk. A large component of this is holding a well-diversiﬁed portfolio. Therefore, proponents of the CAPM model argue

that assets are priced such that investors are only compensated for the
risk that they cannot diversify away.
3.This choice cannot be determined without addressing the individualinvestor’s utility function because neither stock dominates the other interms of risk and return.
4.In pricing assets, only the nondiversiﬁable risk is compensated.
5.This is the market risk premium. This is the expected risk premium forthe market as a whole.

6.Beta is the sensitivity (a.k.a. elasticity) of a stock’s return to changes inthe return on the market.
7.It means that Asset A has more systematic risk than Asset B. However,
it does not mean that Asset A necessarily has more risk (systematic plus
unsystematic) than Asset B.
8.The capital market line is the relation between expected return and risk,
as measured by variance. The security market line is the relation between
expected return and systematic risk, as represented by beta.

9.Plotting above the security market line means that the stock is under-
valued: bidding up the stock’s price will reduce its return, forcing it on
the SML.
10.Expected return =0.02+1.2(0.10 −0.02) =0.02+0.096 =11.6%.

11.An efﬁcient portfolio in the presence of a risk free asset is formed by
combining an investment in the market portfolio with either an invest-
ment in the risk-free asset or borrowing at the risk-free rate.
12.The CAPM cannot be tested unless we specify the correct market port-folio, which is the value-weighted portfolio of all risky assets.
13.The assumption regarding borrowing and lending at the risk-free rate

of interest is questionable because investors cannot borrow at the risk
free rate.
14.The homogeneous assumption in the CAPM is the assumption that all
investors perceive the same expected return and risk associated with the
assets.
15.The law of one price implies that assets that have similar payoffs, both
in terms of expected returns and risk, should be priced the same; if they
are not priced the same, there is an arbitrage opportunity.

16.The fundamental principles of the APT model are that asset prices are
determined by one or more factors and that returns on assets are driven
by unanticipated changes in these factors.
17.The APT is more general because it allows for the possibility of more
than one factor to affect asset prices (that is, it is a multifactor model),
and the APT does not require specifying a market portfolio.
18.The APT factors are unknown, and therefore cannot be adequatelytested.
19.

19.
a.Disagree: Unsystematic risk is nearly eliminated in a diversiﬁed port-folio, whereas the unsystematic risk of an individual asset in theportfolio may be signiﬁcant.
b.Disagree: Investors are compensated only for the risk that they cannotget rid of; investors are not compensated for diversiﬁable (that is,unsystematic) risk because they could reduce it if they wished to by
diversifying.
20.Disagree. As with the CAPM, investors are not compensated for risk

that they could remove but choose not to.

APPENDIX
CHAPTER 18
1.The sum of the real interest rate and the expected rate of inﬂation.
2.The yield spread is 170 basis points. This spread is the additional pre-
mium for bearing credit risk.
3.The investor has the option to exchange the debt for another security ata speciﬁed exchange rate.
4.The muni-Treasury yield ratio =0.025 −0.03=0.83.
5.The rate on a taxable security that is equivalent, on an after-tax basis,to that of a non-taxable security.

6.The difference in yields, expressed in basis points, between Treasurysecurities of different maturities.
7.(1+0.05)
3=(1+0.045)2(1+f); 1.157625 =1.092025 (1 +f);
f=6.01%.
8.The normal yield curve is upward sloping.
9.Expectations regarding future interest rates; liquidity premiums for
longer maturities; preferred habitat among investors; market segmen-
tation.
10.Used as a set of benchmark interest rates for loans and bonds.

11.Market participants generally gauge the credit risk of a bond issue byrelying on the credit ratings by the rating agencies.
12.The greater the credit risk of a bond, the greater the risk premium on
the bond (and, hence, the greater the bond’s yield).
13.Solve for rin the following:
(1+0.046)
2=(1+0.041) ×(1+r)
1.094116 =1.041 ×(1+r)
(1+r)=1.094116 ÷1.041
r=5.1024%

14.
2-year spot rate 1-year spot rate 1-year forward rate
5% 4% (1.1025 ÷1.04) −1 =6.0096%
4% 3.8% (1.0816 ÷1.038) −1 =4.2%
3.5% 3.25% (1.071225 ÷1.0325) −1 =3.7506%
15.Forward rates are not a perfect predictor of future rates because if they
were, then we would know what bond prices would be in the future.Further, empirical evidence indicates that forward rates are not good
predictors.

16.Forward rates are referred to as hedgeable rates because they indicatehow an investor’s expectations must differ from the market consensus
to make a correct decision. The forward rates are a hedgeable measureof future rates.
17.This is an upward-sloping yield curve.
18.By calculating the forward rates, based on today’s rates for variousmaturities, he/she can derive the slope of the yield curve, which suggests
the expectations for interest rates in the future.

19.The “bias” in biased expectations theories is the belief that interest ratesinclude premiums for liquidity preference (that is, risk) and to induce
investors from their preferred habitat.

20.What is described in the quote is a humped yield curve. A humped
yield curve is not consistent with the liquidity preference theory and
the market segmentation theory. However, a humped yield curve may
be consistent with the preferred habitat theory, in which interest rates
are determined by the supply and demand for securities at the differentmaturities.

APPENDIX
CHAPTER 19
1.If earnings grow at a rate similar to the dividends, the dividend payout
will remain constant. However, if earnings ﬂuctuate, this will have theeffect of a varying dividend payout ratio.
2.The greater the discount rate, the lower the present value of the stock.The discount rate should reﬂect the uncertainty associated with the
amount and timing of dividends.
3.The value of the stock will be based on a perpetual stream of cash ﬂows.

Using the dividend discount model, this means that the growth rate, g,
will be zero.
4.The average annual growth is g=(
3√
$3/
$2 )−1=14.47%.
5.The required rate of return must be greater than the expected growth
rate; otherwise, the result does not make sense (that is, a negative value
for the stock).
6.Yes. A negative growth rate still works in the dividend discount model.
7.The expected return on the stock is the sum of the expected dividendyield and the expected capital yield of the stock.

8.
a.Assuming a constant growth rate ad inﬁnitum may not be appropri-ate. Companies tend to experience growth phases throughout theirlife cycles, and the expected growth rates should change accordingly.
b.Growth, transition, and maturity.
9.The estimate is $2 ×15=$30 per share.
10.Earnings captures the results of both operations and ﬁnancing decisions,
whereas sales does not reﬂect operating efﬁciency or ﬁnancial leverage.

11.Value of the stock =$39.7162
YearExpected
DividendExpectedTerminal ValueTotal CashFlowPresentValue
(Cash ﬂow
discounted at 8%)
1 $2.50 $2.5000 $2.3148
2 $3.00 $40.6250 $43.6250 $37.4014
3 $3.25
Value = $39.7162
Note: Terminal value (end of Year 2) =$3.25 ÷0.08=$40.6250
[valued as a perpetuity]
12.Required rate of return =dividend yield +growth rate
12%=4%+growth rate Therefore, the growth rate is 8%

13.Agree. Relative valuation focuses more on the fundamental factors be-
hind the growth, rather than strictly dealing with dividends and expected
growth in dividends.
Disagree: The dividend discount model can be evaluated in terms of
fundamental factors by restated dividends in terms of dividend payoutsand retention rate, multiples, etc.
14.Both the dividend discount models and the relative valuation models
use proxies for the market’s expectations (dividends and growth with

the dividend discount models; comparable companies’ multiples for therelative valuation models).
15.If you are too stringent, you will have a limited number of observa-tions/estimations of the market’s valuation.

APPENDIX
CHAPTER 20
1.Maturity value (FV), yield to maturity (r ×2), number of periods to
maturity (n), periodic cash ﬂow (the interest, or PMT).
2.The use of semiannual periods is to put the zero-coupon bond valuation
on the same basis as the typical semiannual coupon bond.
3.There is a negative relation between the yield on a bond and the bond’s
value: the greater the yield to maturity, the lower the value of the bond.

4.When the yield to maturity is higher than the coupon rate, the bondwill sell at a discount from its face value. This is because the market is
demanding the higher yield than what the bond produces through the
coupon; the remainder of the yield is from the appreciation in the bondfrom its discounted value to its face value.

5.If the bond is selling at a discount from its face value, the bond’s valuewill rise until it reaches its face value. If the bond is selling at a premiumto its face value, the bond’s value will decline until it reaches its face
value.
6.The current yield is a rough approximation of the bond’s true return,
ignoring the time value of money. The yield to maturity considers the
time value of money, and assumes that any coupons on the bond are
reinvested in a similar yielding investment.

7.The yield to worst is the lower of the yield to maturity and the yield to
call for a callable bond.
8.
a.We are assuming that each cash from is reinvested immediately in asimilar yield investment.
b.Coupon rate and maturity.
9.The investor has an option to sell the bond back to the issuer if the bond
is putable.

10.The coupon rate is less than the yield to maturity because the bond is
selling at a discount from its face value.
11.
Market Price Dollar Price
94.0 $940.00
102.0 $102,000
75.0 $7,500
86.4 $864,000
12.PMT =3.5; FV =100; i =4%
a.Not. PV =120→N would be negative (using a calculator)—in other
words, it does not make sense. Therefore, the bond will not trade for
120 if its maturity is more than one year based on the given yield.

b.Not. PV =100→N would be 0, which is not plausible if the maturity
is actually more than one year.
c.Possible. PV =90→N is 41.035, which is slightly more than twenty
years.
13.As a premium the bond approaches maturity, its value converges towardthe bond’s maturity value.
14.The 10-year coupon bond has more reinvestment rate risk because(1) it has a coupon, which requires reinvestment each period, and
(2) it matures sooner than the zero-coupon bond.

15.A callable bond is difﬁcult to value because it is not possible to specify
precisely if and when the bonds will be called from the investors. The
issuer’s decision is based on both interest rates on any refunding andthe costs of issuing new bonds.
16.The convertible bond will trade at the greater of its value as a straightbond and its conversion value, and therefore will trade at $1,100.

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t h e  U n i v e r s i t y  o f  N o r t h  C a r o l i n a  a t  C h a p e l  H i l l  and her BS in accountancy from Miami University. Professor Drake previously taught at Florida State University and Florida Atlantic University. 
FRANK J. FABOZZI, P
HD, CFA, CPA,  is Professor 
in the Practice of Finance and Becton Fellow at 
the Y ale School of Managemen t and Edi tor of the Journal of Portfolio Management . Fabozzi earned a

doctorate in economics from the City University of New York. He is an Afﬁ  liated Professor at the University of Karlsruhe’s Institute of Statistics, Econometrics, and Mathematical Finance and is on the Advisory Council for the Department of Operations Research and Financial Engineering at Princeton University.
Jacket Image: © Jupiter ImagesWritten by the experienced author team of Pamela Peterson Drake and Frank Fabozzi,

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An Introduction to Financial Markets, Business Finance, and Portfolio Management

The 
Nature 
of 
Investing
195612 i-x 1-214 r4pm.indd  i 2/ 19/14  2: 46:25 AM

The 
Nature 
of Investing
Resilient Investment  
Strategies through
Biomimicry
KaTheRIne Coll InS
195612 i-x 1-214 r4pm.indd  ii i 2/ 19/14  2: 46:25 AM

First published by Bibliomotion, Inc.39 Harvard StreetBrookline, MA 02445Tel: 
 61
7-  93
4-  242
7
www.bibliomotion.comCopyright © 2014 by Katherine CollinsAll rights reserved. No part of this publication may be reproduced in any manner whatsoever without written permission from the publisher, except in the case of brief quotations embodied in critical articles or reviews.Printed in the United States of AmericaCIP data applied for
195612 i-x 1-214 r4pm.indd  iv 2/ 19/14  2: 46:25 AM

To my parents, who have taught me
honor and service and faith and love.
To my siblings, who have taught me
kindness and generosity and devotion.
To our next generations.
And to yours.
195612 i-x 1-214 r4pm.indd  v 2/ 19/14  2: 46:25 AM

v i iContents
Part I: Preparing the Ground
Saved By the Bee  3
Th
e Roots of Biomimicry Investing  13
T
he Roots of Biomimicry Practice  19
Part II: Re‑Rooting Investing: Six Transformations
From Efficient to Effective  27
F
rom Synthetic to Simple  49
F
rom Maximized to Optimized  71
F
rom Disconnected to Reconnected  95
F
rom Mechanical to Mindful  11
7
From Static to Dynamic  13
7
Part III: Cultivation and Care
Biomimicry Investing:  
Resilient, Regenerative, Reconnected  15
9

9
Timshel: The Power of Choice  16
5
Notes  16
9
Resources  18
1
References  18
7
Acknowledgments  19
7
Index  20
1
About the Author  20
9
195612 i-x 1-214 r4pm.indd  vi i 2/ 19/14  2: 46:25 AM

When we try to pick out anything by itself, we find it 
hitched to everything else in the universe.
—  Jo
hn Muir
There can never be good for the bee  
which is bad for the hive.
—  Ra
lph Waldo Emerson
195612 i-x 1-214 r4pm.indd  ix 2/ 19/14  2: 46:25 AM

Part I
Preparing the Ground
195612 i-x 1-214 r4pm.indd  1 2/ 19/14  2: 46:25 AM

3Saved by the Bee
One of my most treasured possessions is the gift my father 
gave to me when I started my first job: it’s a sign from IBM, circa 1970. My dad worked there for many years, and so our entire family was constantly surrounded by this motto. Every pencil, every notepad, every coffee mug held this sim-ple command, in classic typewriter font:
THINK.
This sign has come with me everywhere, from a little

cubicle with a scenic view of the ventilation shaft to a big corner office, and it’s only recently that I realize what a true gift it was: embedding in my mind, from my earliest memory, the idea that when you go to work, your job is to THINK.
For more than twenty years I’ve been a professional

investor, and this is what I love most about my profession: it requires you to think, in a proactive, engaged, creative way. Partly that’s due to the fact that the world is always changing. Of course, things have been shifting within the 
195612 i-x 1-214 r4pm.indd  3 2/ 19/14  2: 46:25 AM

th e  N at u r e  o f  I Nv e s tI Ng
4investment business too. In fact, it’s hard to overstate the changes in the structure of our financial markets just over the last twenty years or so.
Take one small example of an investment tool: the heat 
map. Twenty years ago, heat 
 ma
ps—  th
ose red and green 
patchwork charts that display stock prices on every TV finance channel and every investing 
 we
bsite—   di
d not exist.

In fact, when I started as an investor, the Quotron was still our main source of stock prices, and it was down the hall, shared by about a dozen people. This was not an elegant piece of technology: the Quotron weighed at least fifteen pounds, it required a dedicated phone line, and it had one of those tiny green screens that quivered with the sheer physical effort of transporting small bits of data. You had to manually enter each ticker symbol, which led to some long lines around the machine,

which led to some long lines around the machine, especially on days when a lot was happening in the stock market.

But the Quotron, precisely because it was so 
 us
er- 
 un
friendly, brought a great advantage. It was our water

cooler. If you were a semiconductor analyst, this is where you learned about oil prices. If you were a retail analyst, this is where you learned about housing starts. You knew which industries were doing well just by the look on your colleagues’ faces as they checked their top holdings. That crowd around the Quotron connected our individual pods of data into a web that was more like knowledge, and sometimes even wisdom. Just as importantly, it connected us to one another.

There is no question that the heat map is a better, easier 
tool to use for data on stock prices. And these days, you 
195612 i-x 1-214 r4pm.indd  4 2/ 19/14  2: 46:25 AM

sav e d  b y  t h e  be e
5don’t need to be a professional investor to access all of that data every second of every day, right from your cell phone. But something has been lost amidst this efficiency: those hallway conversations have disappeared. The perspective, the exchange, the connection provided in that water cooler 
 se
tting—   th
at’s not something I can carry in my pocket. It’s 
still out there, but it’s farther away than ever.
This cycle of technological improvement has repeated

itself over and over again, with most of our new tools and products and processes bringing big gains in efficiency or speed or scale. But gradually, many of these advances have chipped away at the 
 co
nnection—   co
nnection to the world, 
and to each  ot
her—   th
at has always been at the heart of the 
investment profession.
As the investment business was evolving in this direc-

tion over the years, I felt more and more a sense of personal struggle. I couldn’t quite define its source, or even recog-nize the strain, but at one point during my last few years of money management, I had a long day of client meetings, about a dozen in a row. At the end of the day I realized that every single client had asked me questions about portfolio statistics like tracking error, but only one client had asked anything about an actual investment I’d 
 ma
de—  wh
at the

ma
de—  wh
at the 
company did that was of use to the world, what made it worthy as a place to deploy our shareholders’ funds.
Soon after this, in the face of a tiny market correction 
in 2006 (nothing like what we were to see a couple of years later), my funds underperformed by ten times more than any of our fancy 
 ri
sk-  ma
nagement models said was pos-
sible. Over the course of the next year, my funds recovered 
195612 i-x 1-214 r4pm.indd  5 2/ 19/14  2: 46:25 AM

6and outperformed again, but even after this small crisis passed, I felt a deep sense of 
 di
s-  ea
se. I feared that my pro-
fession was evolving in a direction that was foreign to me. I feared that the tools we’d invented to help us invest wisely were beginning to pull us off course. Importantly, this was not a question of wanting a new job, or even a new career. Investing is my 
 vo
cation —  an
d the idea of splitting from

vo
cation —  an
d the idea of splitting from 
one’s vocation, well, it’s just heartbreaking.
Fortunately, in the midst of all this struggle, I found the 
honeybee.
More precisely, I found Dr. Tom Seeley, the noted

honeybee researcher from Cornell University. Dr. Seeley’s recent work has been focused on collective decision making within beehives. It turns out that bees are not just pretty good at decision making, or above average. They are fan-tastic! For example, bees choose the best available hive location almost every time when they are getting ready to swarm to a new home.
Dr. Seeley’s work is amazing from a scientific stand-

point, but what really struck me was the conclusion of his talk, when he described the key characteristics that enabled the bees’ optimal decision making.
• First, bees go out into the world to gather data. When 
they have an important decision to make, bees do not hole up in a little honeybee conference room and bust out Pow-erPoint presentations. They leave the hive to see what’s out there in their surrounding environment.
• Second, they come back together and engage in

• Second, they come back together and engage in 
active, objective sharing of information. There are no bee 
195612 i-x 1-214 r4pm.indd  6 2/ 19/14  2: 46:25 AM

7spin doctors, no bee talking heads, no bee pundits. They come back to the hive and share what they’ve learned, openly, directly, and objectively.
• Third, they reiterate this process until the informa-
tion is complete and compelling.
• Finally, and most importantly, bees have a clear, 
shared common value system.  They all know what makes for 
the best hive location, and those are the criteria upon which their decisions are based.
1 There are no hidden agendas, no

1 There are no hidden agendas, no 
political  mo
tives—   th
e bees just seek the best answer.
As Dr. Seeley talked, I felt more and more excited, and 
also, curiously, more and more at ease, a sense of ease I had not felt in a long time. I realized that the honeybees’ characteristics are the exact same ones that lead to the best investment decisions.
The best investors I know go out into the world, observ-

ing, interacting, gathering information. They do not expect investment ideas to pop out of the screens on their desks; the best ideas come from the real world. And once they have an initial thought, great investors want to debate it, especially with others who might have different informa-tion. They are not concerned about pitching stocks or win-ning a 
 so
und-  bi
te contest; they want to be challenged by

te contest; they want to be challenged by 
other informed people who have different points of view. And finally, great investors have a clear, strong value sys-tem. It’s so clear and so strong that they often don’t even stop to think about it, but when they see an opportunity that is a match for their approach, for their own definition of good investing, it is clear as day.
195612 i-x 1-214 r4pm.indd  7 2/ 19/14  2: 46:25 AM

8I realized as Dr. Seeley spoke that the core of my pro-
fession was completely intact. In fact, it was beautifully aligned with the basic, brilliant principles that govern the natural world. It turned out that this struggle I felt was not against my vocation, the profession of 
 in
vesting—   my 
strug-
gle was against the business of investing, all of the tools

and mechanics and distraction that we’ve created. These tools are each helpful in their own small ways, but their cumulative effect had been to gradually pull me off center, away from the essential, connected nature of investing.
So, I decided I needed to be more like a honeybee. To 
deliberately refocus on an investment approach that was more open, more connected to the world, and more explic-itly focused on its guiding value system.
This re
-roo
ting involved some change. I left the hive,

-roo
ting involved some change. I left the hive, 
the firm that I had loved, the professional home where I had thrived for almost twenty years. This was the place where I had taken on my first glamorous assignment fresh out of college, as a cement industry analyst. This was the place where I had managed my first sector fund, at the shocking age of 
 tw
enty-   tw
o (never fear, I was very well supervised).

This was the place where one company management team brought cake to our update meeting, because they knew I’d be working late on my birthday. This was the place where I’d managed billions of dollars, where I’d met count-less CEOs and analyzed hundreds of businesses. This was the place where I’d taken on the toughest management role of all, managing an intense and brilliant team of people (much more challenging than managing money). In that hive, I had had more opportunity than I’d ever dreamed

9had worked side by side with some of the best investors of all time, had learned and been tested in every possible way, and, best of all, had forged many dear, lifelong friendships.
Leaving my home colony, needless to say, was both

exciting and unsettling. I reengaged in the world around me, travelling as a volunteer and a pilgrim. I earned a degree at Harvard Divinity School, to strengthen my own core of values that underpin all decision making. And I started Honeybee Capital, with the simple premise that pollination of ideas, connection to the real world, and a strong underlying value system lead to optimal investment decisions.
Dr. Seeley’s honeybees have now led me on a longer

journey, a broader exploration of how all sorts of natu-ral systems can provide us with road maps for our own 
 hu
man-   cre
ated systems. Thanks to the generosity and

vision of Janine Benyus and Hazel Henderson, who led a joint gathering of biomimicry leaders and investment inno-vators in 2011, ultimately my research has led to a deeper study of biomimicry, a framework for understanding the key characteristics of all natural systems and organisms. Applying the principles of biomimicry (life’s principles) to investing gives us an approach that realigns and reinte-grates our investment activity with the world around us.
The 
 bi
omimicry-   ba

The 
 bi
sed framework offers several key 
advantages:
• It 
is the ultimate in sustainability . Nature has sus-
tained for 3.8 billion years! In fact, it goes beyond sustainable: nature is adaptive and regenerative.
195612 i-x 1-214 r4pm.indd  9 2/ 19/14  2: 46:25 AM

1 0• It is nonjudgmental . Nature can be a wonderful 
instructor, but it is not preachy. Nature just is. 
Nature does not lecture you; nature demonstrates how the world actually functions.
•
 It
 is an inherently integrated approach . No single 
component of a natural system exists in isolation. Employing biomimicry automatically employs a networked, 
 sy
stems-   ba
sed, integrated methodology.
• It 
is inspiring and comforting. Relying on deep,

is inspiring and comforting. Relying on deep, 
functional knowledge, embedded in ancient, real, observable natural systems, feels a lot better than taking up the latest clever (but limited) business school buzzwords. And the examples provided by nature are just stunning in their elegance and effectiveness.
•
 It 
is flexible and durable. Life’s principles focus on

adaptability, local responsiveness, and resource efficiency; they incorporate and anticipate all sorts of environments and changes. These are not ideas that become suddenly invalid when things shift. Just the opposite, they are even more illumi-nating in times of flux.
•
 It 
is un‑fluffy. Nature is not all rainbows and kit-

tens, and natural systems certainly do not sit in a romantic state of perpetual balance and bliss. It is the disruptions in nature, and the responses to them, that can teach us the most.
As I have employed these biomimicry principles more 
and more in my own investing, I have found greater clarity 
195612 i-x 1-214 r4pm.indd  10 2/ 19/14  2: 46:25 AM

1in my decision making, greater total returns (both financial and nonfinancial), and yes, greater joy. Investing accord-ing to life’s principles has led me away from the overly engineered, disconnected, mechanical parts of finance. I still use many of those helpful tools, but they are now in their proper context: used as tools only, not as drivers of my decision making. And I’ve been able to refocus on the connected, integrated, mutually beneficial activity that rep-resents investing in its

activity that rep-resents investing in its truest and best form.

This is where real value is created. This is where our 
future lies. Biomimicry investing requires our most intel-lectually and emotionally robust resources. It requires us not to react blindly to numbers on a screen, but to engage proactively with the world around us. It requires us to uti-lize our full, independent, creative, multifaceted minds. It requires us, in the broadest and most inspiring way, to THINK.
195612 i-x 1-214 r4pm.indd  11 2/ 19/14  2: 46:25 AM

1 3The Roots of Biomimicry Investing
Two things fill the mind with ever new  
and increasing wonder and awe:   
the starry heavens above and the  
moral law within.
—Immanuel Kant,  
Critique of Practical Reason1
We are all investors. We invest our time, our energy, our

money. We invest every single day, as citizens, as consum-ers, as businesspeople. At its core, done well, investing is well aligned with nature. It involves connection, exchange, and mutual benefit: we humans invented this activity, to serve our own needs, our communities, and our planet.
Lately, however, this primary, beneficial function 
of investing has become overshadowed by 
 ev
er-  mo
re- 
 ex
tended iterations of finance . In my definition, finance

consists of all of the secondary activity that’s related to those initial exchanges: in its earlier stages finance pro-duced vehicles like the stock market, where activity was 
195612 i-x 1-214 r4pm.indd  13 2/ 19/14  2: 46:25 AM

1 4still closely connected to the real world. You can buy stock in a railroad company, and assuming the price you pay is a fair one, if the railroad business does well, your investment will likely do well, too.
But as our tools have become more and more special-

ized, they’ve taken on a life of their own. We now have funds of funds, securitizations on top of securitizations, and entire firms whose businesses are based on harvesting the advantage of microseconds of trading speed. None of these developments is inherently bad, but each one pulls us further and further away from that primary, useful func-tion of investing: flow of resources and mutually benefi-cial exchange. When we move deeper into the specialized mechanics of finance, we often end up in

mechanics of finance, we often end up in the realm of spec-ulation, and lose sight of the primary role of investing.

Additionally, as risks and uncertainties have mounted 
in recent years, we’ve sought more control over our invest-ing. The trouble is, driven by fear, we have focused on the wrong goals. Instead of aiming for resilient, optimized portfolios, we have sought 
 ri
sk-  fr
ee,  re
turn-   ma
ximizing

strategies that promise to sail through uncertain conditions unscathed. Or we’ve sought more safety, protection at any cost. These approaches might sound great, but they are fig-ments. Fiction. Our faith in mechanics has become stronger than our faith in human judgment. Our faith in individual tools has become stronger than our faith in a connected whole. Our efforts to confine risk have just rearranged it into different pieces and different places, and in some cases magnified the dangers. We

and in some cases magnified the dangers. We desperately seek control. But what we need is flexibility, adaptability, and resilience.

th e  ro o t s  o f  b Io mImI Cr y  INv e s tI Ng
1 5So what is the result of our intense focus on organiza-
tion, mechanization, and risk management? In many ways it is the worst of all worlds, where risk and uncertainty are increasingly hidden, but undeniably present. Where flexibility and adaptation are constrained by ever smaller 
 in
vestment-   st
yle boxes and ever greater layers of processing

yle boxes and ever greater layers of processing 
(and cost) between the investor and the investment. Where our structures and systems are increasingly complicated, but without the benefits of variation and diversity. Where our investment products are more and more numerous, but controlled by fewer and fewer entities.
It is now widely recognized that our financial system is

not as robust nor as resilient as we’d hoped and planned, and proposed reforms tend to focus on ever more complex regulation, with increasingly esoteric bureaucratic levers in the system. The premise is that if we make the rules dense and detailed enough, we will somehow be protected.
What my own journey as a professional investor has

shown is that there is a time to “go deep” like this, to dive into more specialized pools of knowledge and tactics. How-ever, there is also a time to “cut across,” to look for other models that are not specialized, but rather more connected and universal. It may be appropriate to regulate the 
 mi
cro- 
 le
vel details of the financial business , but I also believe that 
the time has come for us to refocus on the investing profes-

sion. We need to reengage with investing in its essential, connected 
 fo
rm—   to 
reintegrate our profession with the 
real world, instead of the world on the screen.
How can we re -ce
nter our focus on investing in this 
original, beneficial role? Traditional economic theory, 
195612 i-x 1-214 r4pm.indd  15 2/ 19/14  2: 46:25 AM

1 6upon which traditional investment theory relies, can be useful, but it is incomplete. These theories take a mechani-cal approach, and to do so they must begin with a series of disconnects. One of the first phrases that any Econ101 student learns is “ceteris paribus,” “all else constant.” But “all else” is never constant. Likewise, a long list of “exter-nalities” is ignored in all sorts of economic studies and business decisions, even when those externalities are vitally important, and not

externalities are vitally important, and not external at all. This does not make tra-ditional economic theory useless, but, like any set of tools, we need to be conscious of its shortcomings.

Re
-roo
ting investing is no small task. It requires a phil-
osophical framework that is flexible enough to apply to many layers of a system, yet steady enough to apply to all sorts of shifting circumstances. It requires ideas that are aspirational, yet still easily linked to practice in the real world. It requires tools that are connected to deep truths and observable facts.
Biomimicry fits this bill. It is both philosophy and prac‑

tice. A provocative, nuanced approach to transforming finance is to use biology instead of mechanical engineering as our starting point for modeling. Specifically, biomim-icry provides us with a model that embodies connection and integration, a model of our natural systems that have proven to be effective, adaptive, and sustainable for 3.8 bil-lion years. This is not a nifty new quantitative approach or a fancy consultant’s pitch; the principles of biomimicry, life’s principles, describe how

of biomimicry, life’s principles, describe how the natural world actually functions. As educator Dayna Baumeister notes, “biomim-icry is an emerging discipline of an ancient practice.”

1 7This is not the newest theory. This is our most ancient

wisdom. In my own search for a more complete, recon-nected approach to investing, I was fortunate to find my mentors in biomimicry, Janine Benyus and Dayna Bau-meister. The visionary futurist Hazel Henderson drew us together with other biomimicry and investing enthusiasts at a small gathering in 2011, and by noon on the first day I realized that, though we were deep in discussions about all that was flawed in our current world, I was breathing more deeply. I was wide awake. I was smiling.

more deeply. I was wide awake. I was smiling. Unlike some sus-tainability frameworks, biomimicry does not root itself in anger and blame. It begins with acknowledging the reality of connected systems, and from that springs a natural and genuine sense of responsibility, stewardship, participation, and care. While a

bl
ame-   ce
ntered approach begins with 
liability, shame, and negativity, a  re
sponsibility-   ce
ntered 
approach begins with agency and positivity.3
As we sank into deeper and deeper conversation in

Hazel’s Florida backyard, I felt more than optimistic, more than hopeful. I felt a great sense of homecoming. I felt pow-erful. For the first time since I’d begun working in sustain-able investing, I did not feel the need to convince anyone that I was right (or righteous). Janine and Dayna’s work reminds us that this is how the entire natural world func-tions: it is our choice whether or not to align with nature’s principles in the short term, but ultimately, they do prevail. There’s a reason

but ultimately, they do prevail. There’s a reason we say, “don’t mess with Mother Nature.”

This book’s discussions of biomimicry and of life’s 
principles draw heavily on the work of Janine and Dayna, on materials they’ve published, and on teaching and 
195612 i-x 1-214 r4pm.indd  17 2/ 19/14  2: 46:25 AM

1 8discussions that form the Biomimicry Specialist educa-tional program.
4 It also builds upon the inspiring vision 
set forth in the Principles of Ethical Biomimicry Finance, 
authored primarily by Hazel, Janine, and Rosalinda San-quiche after that initial gathering in Florida.
5 I offer these

5 I offer these 
highlights, plus my own interpretations of their applica-tions to investing, with tremendous gratitude to Janine, Dayna, Chris Allen, Hazel, Rosalinda, and all of our many colleagues throughout the years. Not only are these people brilliant and pioneering intellectuals, they are also gener-ous and compassionate teachers and doers.
195612 i-x 1-214 r4pm.indd  18 2/ 19/14  2: 46:25 AM

1 9The Roots of Biomimicry Practice
In its simplest form, biomimicry is a straightforward prac-
tice. It’s pausing before every creation, every decision, every design, and asking ourselves, “what would nature do here?” WWND?  This phrase asks us to draw on the wisdom of

nature before jumping to our preprogrammed, engineered default mechanisms. It opens us up to creativity and con-nection. The “here” adds an important nuance, remind-ing us that context is vital. We don’t want to cut and paste convenient, random pieces of nature’s guidance; we want to explore deep layers of wisdom within their appropriate context.
What nature would do is tangible; it is observable all

around us. Perhaps that’s why a long walk can be the best remedy for writer’s block, or the best way to calm down after an anxious or angry encounter. Nature is sustaina-ble; it is geared to optimize; it is inherently connected and regenerative. And because of all those things, it is aligned with the deepest human wisdom, whether from philoso-phers or spiritual leaders or indigenous communities. Or 
195612 i-x 1-214 r4pm.indd  19 2/ 19/14  2: 46:25 AM

2 0perhaps it is more appropriate to say that they are aligned with nature.
In its more complete application, biomimicry asks us to 
look to nature as model, mentor, and measure. As model,

nature offers lessons from 3.8 billion years of sustainabil-ity. We can use these lessons to innovate our own products and processes to be more in alignment with life’s princi-ples. As mentor, nature provides us with wisdom, not just raw materials. And as measure, nature offers clear tests for whether any endeavor meets standards of truly 
 lo
ng-  te
rm, 
 fu
ll-  cy
cle, integrated sustainability. To these three, I would 
also add “muse,” as I have seen firsthand how much crea-

tivity can be unleashed by simply observing the wonders living all around us.
Biomimicry is also inherently a multilayered approach : 
the same framework can be applied to forms, processes, and entire systems. This makes it perfect for applying to a multidimensional area like investing, where one of our biggest challenges has been the development of tools and languages that are 
 ul
tra-  sp
ecific to small pieces of the field, 
without linking back to the whole.

Similarly, biomimicry is scale agnostic : it can be applied 
at micro, meso, macro, and meta levels. In my work I use biomimicry to look at individual companies, my own investment processes, investment products and tools, and the entire financial system. The contexts are specific and varied, but the principles are universal.
195612 i-x 1-214 r4pm.indd  20 2/ 19/14  2: 46:25 AM

th e  ro o t s  o f  b Io mImI Cr y  P r a CtI Ce
2 1Here’s What Biomimicry Is Not
Biomimicry is not an overly romanticized view of the world and its functions. Nature is not just sunshine and puppies; it is also hurricanes and vipers, droughts and rats. We can learn from the darkness of nature as well as its light. Nature demonstrates systemic principles that are often different from the ones used in 
 hu
man-   cre
ated systems, and natu-

hu
man-   cre
ral systems also adjust to change and disruption differently (and usually better) than 
 hu
man-   cre
ated systems. There 
are frequent, large disruptions and imbalances in nature, but throughout all of that, life strives to create conditions conducive to life. We can learn from these disruptions and adaptations as much as (and maybe even more than) from an ongoing healthy system.
Perhaps most important, biomimicry is not just copying

nature, like the mechanical hummingbirds recently devel-oped by DARPA. It is not pasting nature into nonnatural environments, like adding bamboo flooring to a 
 hi
gh-  ri
se 
in the desert. And it is not simply employing nature as if it were a subcontractor, taking bits and pieces that are use-ful to us, without regard for context, process, or system. Biomimicry focuses on embracing nature’s wisdom, not extracting nature’s stuff. This starting point is one of open inquiry and 
 cu

cu
riosity—   as
king “how” instead of “how 
much.”
195612 i-x 1-214 r4pm.indd  21 2/ 19/14  2: 46:25 AM

2 2Getting Started
Since biomimicry is scientifically rooted, it is tempting to jump right in with our linear minds, to begin analyzing its principles, implementing its practices, following its check-lists straightaway. And yet to be most effective, there are three essential, qualitative points of orientation needed before we begin.
First, rearrange : nature is not separate from 
 us
—  we 
a
re nature . This idea is obvious and yet sadly unfamiliar,

because we are often conditioned to think of nature “over there.” Even some of our most ardent environmental move-ments are premised on the need to save the whales, or the rainforest, or the spotted owl, as if these elements are dis-tant from ourselves, when in fact they are all part of our own larger, connected ecosystem. Sometimes the notion of human agency leads us to stay stuck in a disconnected state, thinking we are acting “for” or “against” instead of “with” our fellow creatures.

The second orientation point is the recognition of how 
investing and finance fit into our broader world. Espe-cially for those of us engaged in investing professionally, the financial markets can sometimes take on a life of their own. They seem like primary drivers of our own lives, of the economy, and of our societies, when in reality, of course, finance is just one smallish subset of our total activity. Reframing investing as just a fragment of human

endeavor, and reframing human endeavor as a fragment of 
195612 i-x 1-214 r4pm.indd  22 2/ 19/14  2: 46:25 AM

2 3our natural environment, is a necessary  ta sk—  an d a hum-
bling one.
The third adjustment has been trickiest of all for me: 
refrain . For many years, like lots of us, I’ve been trained to

be as quick and clever as possible, especially in professional settings. And when I am exposed to an exciting new idea, these tendencies are all the more heightened. I want to solve the puzzle, fast. I want to win. But for effective biomimicry practice, we need to quiet our cleverness . In order to learn 
from nature, we need to observe with an open 
 mi
nd-  se
t, 
without actively seeking an answer right away.
This  qu
iet-  min
dedness has similarities to “beginner’s

dedness has similarities to “beginner’s 
mind” in meditation practices, where even experienced prac-titioners are encouraged to approach their practice with open-ness and equanimity. This same concept is present in some of our best investment practices, since any investor who hunts with too narrow a focus for opportunities is sure to miss out in two ways. First, she’ll miss anything that is outside of her 
 na
rrowed-  
 do
wn scope of vision. And second, she will be

do
wn scope of vision. And second, she will be 
tempted to force false conclusions from that small data set. Without some sense of the broader context, some sense of how the micro fits with the macro, a sound decision is impos-sible. This is not to imply that there is no need for focus, but to emphasize that that focus must be undertaken after gain-
ing an understanding of the surrounding environment.
Perhaps this kind of indirect beginning sounds a little 
too 
 pa
tient—   af

too 
 pa
tient—   af
ter all, our challenges are urgent! But it’s 
not so difficult or time consuming to get started. Here are the simple instructions:
195612 i-x 1-214 r4pm.indd  23 2/ 19/14  2: 46:25 AM

2 4Go outside.Breathe deep.Again.Try to 
 loo
k—  wi
thout searching.
Try to  li
sten—   wi
thout hunting.
 Wa
it—  ju
st a little while.
Then begin.
195612 i-x 1-214 r4pm.indd  24 2/ 19/14  2: 46:25 AM

Part II
Re‑Rooting Investing: Six Transformations
195612 i-x 1-214 r4pm.indd  25 2/ 19/14  2: 46:25 AM

2 7Transformation 1
From Efficient to Effective
Several years ago, I sat down with my parents to review 
their investments as they planned for retirement. There was nothing too crazy to 
 dis
cuss—   th
ey held no hidden 
Cayman Island accounts, no illiquid private equity funds, no 
 tim
e-  sh
ares in the Everglades. But there was a lot of 
complication for what was a simple savings plan: no fewer than eight different forms of 
 go
vernment-   ba
cked savings

vehicles, plus a long list of mutual funds that all mainly invested in large U.S. companies. Over the years, each time there was a chance to save a little more, my parents were guided to a new opportunity, and each opportunity was perfectly reasonable. But after forty years of new opportunities, rather than diversification, my folks had a lot of needless duplication. Just as importantly, they had account statements from all sorts of institutions coming out of their ears, which meant a lot of

coming out of their ears, which meant a lot of time and energy were required just to keep all of their records straight.

I see the same tendencies in my own consumption pat-
terns, a sort of unintentional and unnecessary stockpiling. My cupboard often contains multiple cans of tomatoes, 
195612 i-x 1-214 r4pm.indd  27 2/ 19/14  2: 46:25 AM

2 8just because I can’t recall what’s there. My closet contains no fewer than ten black T
-sh
irts, just because the newest 
one seems a little better or different. My portfolio sum-mary lists dozens of stocks, just because each seems unique and intriguing. If these choices add something 
 val
uable—  
 wh
ether it’s better fashion choices or the enjoyment of 
learning about new  co
mpanies—   th
at’s fine. But in many

at’s fine. But in many 
cases, like my parents’, more does not mean better. When it comes to investing, what we need is not more compli-cation, or false variety. We need deeper 
 ef
ficiency—   tr
ue 
effectiveness.
Nature’s Principle: Be Resource and Energy Efficient
If there’s one thing Wall Street is supposed to have right, it’s efficiency. As recently as the early 1990s, just having the fastest fax machines or the bandwidth to receive 
 re
al- 
 ti

re
al- 
 ti
me stock quotes could be a big advantage to an investor. 
Now, just twenty years later, those forms of efficiency seem quaint: large firms spend billions of dollars for 
 ul
tra-  fa
st 
trading systems, there are text crawlers that can automati-cally flag phrases like “lower guidance” or “higher reve-nues” in press releases, and I have seven different apps that provide me with 
 re
al-  ti
me stock quotes right here on my

re
al-  ti
me stock quotes right here on my 
phone. But efficiency is not just about speed, and it’s not just about cost. “Fast and cheap” is a common but shallow form of efficiency, one that feels good in the short term, but ultimately has hidden costs.
The natural principle, be resource efficient, reflects a 
195612 i-x 1-214 r4pm.indd  28 2/ 19/14  2: 46:25 AM

fr o m  ef fI C IeNt  t o  ef f eCtIv e
2
9much more nuanced, much deeper form. In nature, effi-ciency includes sophisticated design principles, like mul-tifunctionality, and fitting form to function. Natural efficiency is not the same as a quick fix; it is true effective-ness. The subprinciples of resource efficiency are:
•
 Use 
multifunctional design.
• Use  lo
w-  en
ergy processes.
• Re
cycle all materials.
• Fi
t form to functions.
For example, have you ever seen a duck preening itself

beside a pond? I have to admit, it never seemed a remark-able sight to me, until I learned about the amazing design elements of the duck’s preen oil. This oil is amazing stuff, and a great illustration of the subprinciple of multifunc‑
tional design : it is produced by the duck’s own body, can be 
used for both feather waterproofing and 
 du
ck-  bi
ll moistur-

du
ck-  bi
izing, and it breaks down into vitamin D when exposed to sunlight. This oil is not just an efficient product by shallow standards (fast and cheap); it is effective , performing many 
functions with simple, internally sourced materials.
1
A perfect illustration of the second efficiency subprin-
ciple, use  lo
w‑ 
 en
ergy processes , is the toco toucan. The

w‑ 
 en
ergy processes , is the toco toucan. The 
toucan’s bill serves many purposes, and one of the most interesting is as a heat exchanger. When it’s colder, the tou-can reduces blood flow to its bill, keeping more of that heat inside. And when it’s warmer, blood flow increases, allow-ing more heat to escape through the large surface area of the bill. The toucan does not need to flap its wings to get warm 
195612 i-x 1-214 r4pm.indd  29 2/ 19/14  2: 46:25 AM

3 0or seek out an external,  hi gh-  en ergy cooling mechanism: 
this adjustment all happens internally, and efficiently.2
The third subprinciple in this section, recycle all mate ‑
ria
ls, is well demonstrated by the hermit crab, source of 
many childhood nightmares for me (click  . . . 
 cl
ack . . . 
 cl
ick).

cl
ick). 
If I’d known about the principles of resource efficiency, at least I could have put that sleepless time to good use, think-ing about how effective the hermit crab is in finding its home. Hermit crabs are the squatters of the seaside scene: they find an empty shell and move right in. But they don’t take just any shell: their behavior is influenced by both what’s available and by the condition of their current dwell-ing. Shells are recycled constantly, in a way that maximizes benefit.

3 Maybe they are not as flashy as the  bi g-  bi lled tou-
can, but the crabs illuminate  re
source-   ef
ficiency principles 
just as the birds do.
The final subprinciple related to efficiency, fit form to 
functions, is elegantly embodied in all sorts of organisms, such as the cactus species lophophora . This type of cac-

tus is designed to shrink when water is scarce, so much so that its shoots flatten out and retract all the way under-ground. Then when water is available, the shoots pop back up again aboveground. The form is perfectly designed to fit the essential function of water management.
4
As we translate the principles of resource efficiency

from biological settings to a human setting, it’s impor-tant to note three fundamental concepts that are embed-ded within the directive to “be resource efficient.” First, form and function go hand in hand, and are based on need. Performing unnecessary functions is, by definition, 
195612 i-x 1-214 r4pm.indd  30 2/ 19/14  2: 46:25 AM

3
1not efficient, since there is no meaningful benefit pro-duced. And providing function with a mismatched form is wasteful, using more energy and resources than are truly required. Say you have two forms of 
 tr
ansportation—   yo
ur 
feet and a sailboat. And you have two  de
stinations—   th
e 
corner store and a remote island. Well, none of these com-ponents is inherently “good” or “bad”—
  bu
t the combina-

bu
tion of your feet and the trip to the corner store obviously matches form and function, whereas it would waste a lot of energy to try to walk (or swim) to that island. Behind every function is a need, and for every function there is a form. If it’s a really good form, it fits numerous functions with one design.
The second underlying idea is the relationship between 
efficiency and effectiveness . Sometimes things that are

efficient are also effective, like the toucan’s bill or cactus shoots. But sometimes we are so focused on shallow, 
 lo
w- 
 le
vel definitions of  ef
ficiency—   li
ke  sp
eed—   th
at we fall far

short of the mark for deep, true effectiveness. For exam-ple, there is a small restaurant on Charles Street in Boston where seating is very limited. Instead of everyone rushing for the few empty chairs, the managers ask that you stand in line, order, and only take a seat once you have your food. This small adjustment is deeply uncomfortable for many customers: you can see the furrowed brows, the glances over shoulders, the occasional coat draped over a chair despite a large sign noting the

over a chair despite a large sign noting the seating policy. The desire to save a seat now is powerful, even though it’s not tied to

an immediate need. This 
 wa
it-  an
d-  si
t approach seems inef-
ficient but it is truly effective: there are exactly the right 
195612 i-x 1-214 r4pm.indd  31 2/ 19/14  2: 46:25 AM

3 2number of seats available at exactly the right time, result-ing in 
 ne
ar–  10
0 percent occupancy. True, the seating proc-
ess is not  su
per-  sp
eedy. This is a more profound form of 
efficiency, optimizing time, space, and expense.
The final embedded concept is one of duration. Effi-
ciency in a natural context takes a  fu
ll-  cy
cle, multidi-

ll-  cy
mensional view, unlike many human endeavors. If a new manufacturing process uses less material, but is much more energy intensive and leaves toxic by
-pr
oducts at the end, 
it is not in alignment with the  re
source-   ef
ficiency princi-

source-   ef
ple. Managing across many dimensions and multiple time frames is harder, for sure. To align fully with this principle we need to include elegant, multifunctional design; mate-rial and energy efficiency; recycled and recyclable materials; and fitting form to functions. This is a much more daunt-ing task than just aiming for “cheap right now.” But if it’s harder, so what? As Jack Welch has said, we need to eat, and we need to dream.

5 Or to quote my mom, “Honey, that’s 
why they call it work. It’s supposed to be hard.”  Ai
ming for 
deep effectiveness does not offer shortcuts or partial credit: we need to embrace the nuance as much as the headline. We are all already functioning effectively across numerous set-tings, every day; as citizens, as 
 bu
sinesspeople, as artists, as 
innovators, as family members, and yes, as investors. These natural principles acknowledge that 
 mu
ltidimensional 
 re

mu
 re
ality, and extend it into more realms of practice.
195612 i-x 1-214 r4pm.indd  32 2/ 19/14  2: 46:25 AM

3
3Translation to Investing
It’s tempting to claim that  re source-   ef ficient investing is 
already alive and well. For each of the efficiency subprin-ciples, plenty of financial illustrations come easily to mind. Take the fundamental building block of 
 mo
ney—   it 
is

mo
ney—   it 
is 
certainly multifunctional, able to serve as a store of wealth, a measure of transaction value, and, in hyperinflationary periods, as wallpaper. Additionally, there is almost no cost http://www.nature.com/news/how-honeycombs-can-build-themselves-1.13398
Figure  1–  1 Re source and Energy Efficient: The Honeycomb

Sure, it is aesthetically pleasing, all of those hexagons arranged row by row, but these also are the most efficient shapes: hexagons use less material (and less energy) per unit of structural integrity than any other standard shape.
195612 i-x 1-214 r4pm.indd  33 2/ 19/14  2: 46:25 AM

3 4to trade securities these  da ys—  so surely that is a  lo w-  en ergy 
process. Speaking of securities, we are constantly trading and retrading the same 
 on
es—  th
is seems to be recycling 
materials. And there are so many forms that investment can take, well, surely we can argue that its forms fit all sorts of functions.
Oh, but there’s the key. Function. What is the function 
of investing? What is its purpose? What constitutes truly effective 
 in

in
vesting—   be
yond a  fa
st-  an
d-  ch
eap, shallow, 
transactional efficiency? What would an investment look like if it were aligned with all of the nuances of resource efficiency? A mismatch between investment form and func-tion can have vivid and significant consequences.
For example, who can forget the famous Good Will 
Hunting scene, where Will 
 ou
t-  qu
otes the obnoxious grad

ou
t-  qu
otes the obnoxious grad 
student and notes that the same education is available for a small expense in library late fees instead of thousands of dollars in tuition. The grad student sneers that that may be true, but at the end of his education, he’ll have a degree, unlike Will.
6 And there you have it, the  me ga-  qu estion. 
What is the function of investing in education? To be educated, or to have a degree? If it’s the former, Will’s 
 ap
proach—   in
vesting  ti
me—   is

ap
proach—   in
vesting  ti
me—   is 
obviously the best fit, and 
the grad student is foolish to spend all that money. But if the degree is what’s valued instead, then those 
 ma
ny-  th
ousand-  
 do
llar tuition payments might indeed be a  re
source-   ef
ficient 
path.
So the real question we ask needs to include both func‑
tion and context : what is the purpose of investing in this 
situation? For individuals, this can sometimes be answered

3
5in simple monetary terms, like, “I need income of $5000 per year from this investment.” Or it can be answered in multifaceted terms, such as, “I want to support my local agricultural community, and I need this money back in two years.” In some cases these answers reveal more complex personal priorities, like, “I need this money to buy a house someday, but I want to honor my aunt who was an 
 an
ti- 
 wa

an
ti- 
 wa
r protester, so I’d like to invest in a way that promotes 
peace.” You can see why we often avoid this kind of nuance in defining investment function: it’s much more difficult! But it’s more interesting, more true to life, and ultimately it can be more rewarding.
For investment professionals, the context may be differ-

ent from an individual investor’s, and the answers may be even tougher to come by. If your firm is introducing a new investment fund, why? What need is it fulfilling? If the pur-pose is to grow your own business, that’s 
 fin
e—  ju
st say so,

fin
e—  ju
st say so, 
and settle the surrounding questions of form and process accordingly. If the purpose is to provide a new or differ-ent service to your clients, why is that new service needed? What sort of form best fits that purpose? Perhaps the appro-priate form is partnership with other providers, or use of processes that already exist elsewhere, rather than expend-ing energy and expense in creating your own offerings.
Many of the biggest mistakes in the history of finance

are rooted in misstated or made
-up 
statements of need. 
Who needed tulip bulbs in 1637? Hardly  an
yone—   or 
at 
least far fewer than the number who wanted tulip bulbs, 
which led to tulip mania and the subsequent crash, all out of alignment with principles of efficiency and effectiveness. 
195612 i-x 1-214 r4pm.indd  35 2/ 19/14  2: 46:25 AM

3 6Note that the definition of need is not required to be noble or 
 ri
ghteous—   ju
st clear and true. And, most importantly, 
the needs can  va
ry—  th
ere is not one single purpose for 
investing, nor should there be.
With a clearly identified need, it becomes much easier

to find forms that fit, to see which materials will be best suited for the task at hand, and to ensure efficient, multi-functional design of investing approaches. Understanding purpose is the root of what takes us from merely fast and cheap to deeply efficient and effective.
Natural Scorecard: Investment Helpers

I’ve been thinking about these questions of purpose with respect to my parents and their retirement savings. If, at each step of the way, we were able to clearly assess need, form, and function, we would be unlikely to end up with a dozen different retirement accounts (or a dozen cans of tomatoes), all performing the same essential function. In the case of my folks, luckily, the duplication was benign: it added com-plication, but not significant cost or risk. But that’s not true for many

cost or risk. But that’s not true for many investors, who often encounter waves of complica-tions that have great big price tags attached.

Consider a 
 pl
ain-  va
nilla solution for many investors, 
the mutual fund. An actively managed fund has average fees of about 
 se
venty-   se
ven basis points (bp) a year; this 
means you pay 0.77 percent of your  mo
ney—  $7
.70 for 
every $1000 you’re  in
vesting—   to 
the manager every year, 
whether performance is up, down, or sideways. An index 
195612 i-x 1-214 r4pm.indd  36 2/ 19/14  2: 46:25 AM

3
7fund is much lower cost, only thirteen basis points annu-ally, but still, there is a fee.
7 And what do you get for this 
fee? Well, you get professionals looking after your assets. You get accurate accounting and tax records. You get peace of mind knowing that others are worrying about the finan-cial markets on your behalf. Alas, you do not get superior

performance, at least not automatically; across all equity and fixed income categories, less than 50 percent of actively managed mutual funds have outperformed their bench-marks on a 
 te
n-  ye
ar basis, and in some categories as many 
as 80 percent of funds underperform.8
Still, this might seem like a pretty fair  tr ade—   good 
s
ervice, diversification, and at least the possibility of supe-

rior returns, in exchange for modest fees. How does the mutual fund investment option stack up against the princi-ples of resource efficiency?
• Does it use multifunctional design? Well, there is 
one major 
 fu
nction—   to 
act as an effective vehicle for 
 in
vesting—   an
d mutual funds are well designed for that. 
Plus, you can use the same fund design for all sorts of 
 in
vesting—   st
ocks, bonds, different regions,  di
fferent-   si
zed

zed 
companies. But these functions are all very closely  re
lated—  
 it
’s not like preen oil for the duck, where it’s a moisturizer 
and water repellant and nutrient all in one.
• Does it employ  lo
w‑ 
 en
ergy processes? Pretty  mu
ch— 
 co
mpared with investing your own time and energy, or 
much more complex investment schemes, mutual funds stack up pretty well. They are easy to use, and are adapt-able with little extra energy required to adjust.

3 8• Are all materials recycled? Hmm, in some ways. 
Components of mutual funds (individual stocks and bonds) are constantly being bought and sold, reconfigured in dif-ferent combinations to produce full investment portfolios.
• Does it fit form to functions?  Fairly 
 we
ll—  th
e form is

we
ll—  th
e form is 
simple and fairly flexible. You can use it to invest in all sorts of different securities, and for all sorts of reasons. But these functions are all closely linked, as noted above.
In short, the answer to all of these questions is some-
where around a B or B minus. Simple mutual funds are aligned with 
 re
source-   ef
ficient principles, but in a pretty 
narrow way.
However, for many these days, mutual funds are con-
sidered child’s  pl
ay—  too

ay—  too 
basic for real, serious investors 
with real, serious investment objectives. Warren Buffett famously wrote about these investors and their waves of “helpers” in his 2005 annual report (that section of his report is titled, “How to Minimize Investment Returns,” so you can see where this is headed). Buffett tells of the fictional Gotrocks family, approached in succession by different sorts of financial helpers. First come the 
 br
oker-  
 he
lpers, followed by  ma

br
oker-  
 he
nager-   he
lpers, followed by consultant-  
 he
lpers, followed by  hy
per-  he
lpers. Each layer of helper may 
be well intentioned, and may provide some value, but each also adds cost to the Gotrocks’ investment process, and in many cases this cost is far in excess of value received.
9 This 
concern applies to institutional investors and their advisors as well as individuals.
10
This might seem like a minor  is sue—   wh at’s a few basis

3
9points in fees, especially if they bring added expertise and sound judgment to your investment process? Let’s add it up. Here is a quick and simple summary of the costs of complication for investors:
•
 In
dex  fu
nd—  ju
st a mirror of securities that are in 
a particular index. Cost = 13 bp.
• Ac
tively managed equity mutual  fu
nd—
“stockpicking” approach, a subset of securities that aims to outperform the relevant index. Cost = 77 bp.
11

11
• Fund of funds  pr oduct—   a b undle of different 
funds, usually with an extra layer of fees. Cost = 91 bp.
12
• Hedge  funds —  a particular kind of fund that has 
more investment freedom, and thus hopefully more chance to perform well. Cost = typically “2 and 20,” or 200 bp annually, plus 20 percent of gains.
•
 In
vestment  ad
visors —  so
meone to help decide

visors —  so
meone to help decide 
amongst the thousands of options available, with the aim of tailoring decisions to your own situa-tion. Cost = 106 bp annually, on top of all of the 
 pr
oduct-   sp
ecific fees noted above.13
This list does not include the even more convoluted 
options that are often used by  hi
gh- 
 ne
t-  wo
rth individuals

gh- 
 ne
t-  wo
rth individuals 
or institutions: funds of hedge funds, extra layers of invest-ment consultants, and so on. And these fees are all annual fees, paid not just once, but every single year, regardless of performance.
195612 i-x 1-214 r4pm.indd  39 2/ 19/14  2: 46:25 AM

4 0There are plenty of times when these sorts of fees are 
justified:  lo
ng-  te
rm investment performance could be great, 
or perhaps an investor really needs and values the assist-ance of an advisor. Perhaps you are investing for reasons that go beyond financial 
 go
als—   su
ch as improving the local 
food web or supporting new  en
trepreneurs—   an
d the nonfi-

nancial information and results that these advisors help to provide are well worth the fees involved. For the record, for many years I was a portfolio manager of actively managed equity mutual funds, and our goal was always to beat mar-ket (and thus index) performance, after accounting for all 
fees. As the chairman of our company used to say, “We are not here for our own amusement.” People were counting on us to steward their 
 ha
rd-  ea

ha
rd-  ea
rned savings in a responsible 
and effective manner. So the point is not simply to conclude “Fees are bad,” but rather to ask the more important ques-tions, “What function is served by these fees? What value do they reflect?”
Even if great value is provided, the costs of investment

fees can be tremendous. Say you invest $100,000 in an index fund for ten years at a fee of thirteen bp per year ($130 in fees for year one). If returns are 5 percent per year, at the end of the decade you have about $161,000—
  a t
otal 
return for the decade of 61 percent. However, if you invest that same $100,000 in a hedge fund, your fees are two 
 hu
ndred bp ($2000 in year one), plus 20 percent of invest-

ment gains. If returns are 5 percent per year, the same as the index fund, at the end of the decade you have $122,000, a total return of just 22 percent for the whole decade. Put another way, because of the higher fees, returns in the hedge 
195612 i-x 1-214 r4pm.indd  40 2/ 19/14  2: 46:25 AM

4
1fund need to be about 8.5 percent per year in order for you to end up with the same amount of money as owning the index fund with performance of 5 percent. At the 5 
 pe
rcent 
performance level, you have paid $39,000 in additional fees over that time period for the hedge fund structure.
This quick exercise shows why road maps like natural 
principles are so 
 us
eful—   be
cause our minds are not well

us
eful—   be
cause our minds are not well 
suited to considering ripple effects and compounding.14 
Even if we intellectually understand the facts about layers of fees, and even if we are great at doing compound math in our heads, 2 or 3 percent sounds small. Here’s the thing: a 3 percent chance of rain means 
 ne
ar-  ce
rtain sun, but a 3

ne
ar-  ce
rtain sun, but a 3 
percent investment fee could set you up for terrible storms. Our brains have a hard time distinguishing between these two very different contexts for “3 percent.”
An assessment of an “
 ul
tra-  he
lped” investment  mod
el— 
 on
e that uses complicated products and layers of  ad
visors—  
 ag
ainst the principles of resource efficiency shows how it 
comes up short:
• Does it use multifunctional design? This sort of

arrangement still serves the major function of investing, but it uses more and more products and inputs to serve the same purpose; this is the opposite of multifunctional design.
• Does it employ 
 lo
w‑ 
 en
ergy processes? As increas-
ingly processed investments and more layers of advisors are added, energy use increases.
• Are all materials recycled? As with our mutual fund 
example, you could say that the components of these funds 
195612 i-x 1-214 r4pm.indd  41 2/ 19/14  2: 46:25 AM

4 2are often traded and reconfigured, but this remains a pretty narrow interpretation of “recycling.”
• Does it fit form to functions?  The 
 hy
per-  he
lped invest-
ing model is inherently more complicated than a simpler approach, and there is little evidence that it performs the essential investing functions better. This seems to be a situ-ation of overengineering rather than a simple, elegant match of form to function.

As noted above, there are times when a complicated, 
multilayered investment approach might make sense, when it matches a similarly multilayered set of needs. But much of the time, this sort of highly engineered approach adds a lot of cost and complication while providing extra features that are not especially relevant, valued, or needed.
Here we come to an important distinction: compli‑
cated versus complex . In this context, the words mean very

different things. A complicated system, or a complicated investment product, is just one that is hard to manage, or hard to explain. It’s difficult, but it’s predictable. A com-plex system, on the other hand (more precisely, a complex adaptive system), is comprised of heterogeneous, connected parts that interact with one another in unpredictable ways and change over time. Therefore, the whole system cannot be described just by summing up the individual pieces; as a collective, the system shows

pieces; as a collective, the system shows emergent properties that make it hard to link cause and effect in a simple, linear way.

15 
Think of a beehive: each bee is performing tasks that are describable, definable, and maybe even predictable. But adding up the actions of each individual bee does not even 
195612 i-x 1-214 r4pm.indd  42 2/ 19/14  2: 46:25 AM

4
3begin to describe the function of the entire hive. A group of individual bees is complicated; a whole hive of bees work-ing together is complex.
There are two reasons why this difference between com-

plicated and complex is so important for thinking about effective investment practices. First, we often take a simple need and match it with a complicated solution or product. Someone just wants to save money for college tuition and before you know it, they are invested through three layers of advisors in a fund of funds, paying 2 percent in fees, when they could fulfill the same essential purpose for 
 on
e- 
 te
nth the cost. The solution is overengineered when com-

pared with the simple function that is required.
Second, we often mistake complex situations for com-
plicated ones. This sort of mistake can be more than costly; it can be devastating. These days we often do have genu-inely complex investment needs: trying to mitigate risk for a big global portfolio that has 
 ev
er-  ch
anging and unpre-
dictable correlations within it, for example. We have tried to address complex purposes like this one by just throwing

more complicated solutions at it. That’s like performing 
highly technical heart valve surgery on someone who has a broken heart of an entirely different sort. Neat technology. Same general location. Totally wrong application. You will never solve the problem this way, just like you will never understand a beehive by watching individual bees. The form does not fit the function.
195612 i-x 1-214 r4pm.indd  43 2/ 19/14  2: 46:25 AM

4 4Evolution
Fortunately, there are increasing examples of reconnect-ing investing needs with simple, elegant, direct solutions. For example, peer
-to-pe
er lending eliminates several lay-
ers of intermediaries by allowing more direct forms of loan making. To be sure, this comes with different characteris-tics than a neatly bundled
-up 
investment product, includ-

-up 
ing different risks, but it also offers more direct connection between investor and investee, which might well make it more aligned with the principles of resource and energy efficiency. Think about 
 it
—  al
l of the resources saved by not 
having three or four sets of institutions involved in bun-dling up the loan (
 lo
w-  en
ergy processes), a platform that

lo
w-  en
ergy processes), a platform that 
can serve the needs of many different lenders and borrow-ers at once (multifunctional design), and a directness that allows for straightforward and simple transactions (fit form to function). The modern incarnations of peer
-to-pe
er

-to-pe
er 
lending are in their infancy, but these are really new tools that extend an old concept, one seen in villages and reli-gious communities and amongst friends and family for centuries. It’s the idea of lending to people you know, com-bining financial risk with social assets, in a way that con-tributes to your own community. Simple, elegant forms of investing.
Other examples of effectiveness can be found in the field

of impact investing. Because impact investors are actively seeking multidimensional returns (beyond just financial returns), established investment “boxes” don’t always fit. 
195612 i-x 1-214 r4pm.indd  44 2/ 19/14  2: 46:25 AM

4
5Consequently, many endeavors end up being very difficult to manage, with reams of legal paperwork and creative but complicated structures. However, organizations like RSF Social Finance, the Calvert Foundation, and TriLinc Glo-bal are offering investment options that streamline those piles of paperwork, meeting multiple functions (financial benefit, social benefit, community connection) in a way that aims to be less complicated, less costly, and more effec-tive for their investors.

Pathway to Practice
What is real efficiency? It’s not just cheap and fast. Deep 
 ef
ficiency—   na
tural  ef
ficiency—   in
cludes complete views

tural  ef
cludes complete views 
across a system and across a life cycle. Instead of asking whether an investment is easy to make, back up and ask, what purpose is this investment serving, and what form best matches that purpose? Then look around and ask, am I duplicating this function? If so, am I adding meaningful diversity, or just expending extra energy and resources by doing the same thing twice?
Once we’re comfortable asking these questions about a

specific investment, we can extend them to consider invest-ing in its broader form. What are the key functions of all 
of your investing, whether you’re investing time, money, or energy? Are the forms you’ve chosen efficient in a deep way, or just fast and cheap? Are there more creative solu-tions than the ones you’ve chosen, solutions that perform multiple functions and use fewer resources?
195612 i-x 1-214 r4pm.indd  45 2/ 19/14  2: 46:25 AM

4 6Our current investment culture values efficiency, but 
often we think of its shallowest form, merely quick and inexpensive. We can reorient this value toward its deeper form of true, systemic 
 ef
ficiency—   re
al effectiveness.
If we’ve been solving investment puzzles by just trying 
to run faster, or by throwing more and more resources at the same type of solution (as in our 
 ul
tra-  he
lper model), we

ul
tra-  he
lper model), we 
can pause to reconsider. What is the real intention of our activity? What functions are we trying to perform? And what forms best match those functions? Perhaps a simpler, more truly efficient form is all that we need, despite the allure of new layers and innovations.
In the end, my parents’ choice of plain old Treasury bills 
and certificates of deposit at their local bank served their purpose quite well for many years, and did so in a simple, 
 re
source-   ef

re
source-   ef
ficient way. These investments did not make for 
good  co
cktail-   pa
rty chatter; they are dull as dirt. But my 
folks were clear on the function they wanted to perform. They just wanted to save some money for retirement, not to engage layers of helpers, not to invest in currency swaps or Brazilian real estate, not to have cool stories to tell their friends. That clarity, and the efficient match of form and functions, has stood them in good stead.

Sowing Seeds of  Re source-   Ef ficient Investing
Here are some simple ideas to start us along a deeply effi-cient path:
195612 i-x 1-214 r4pm.indd  46 2/ 19/14  2: 46:25 AM

4
7• Clarify the underlying functions performed by your 
investments: is it financial return? What sort? What time frame? Is it other sorts of return? Social benefit, commu-nity building, personal or organizational connections? Nature does not falsely settle on a single function, and nei-ther should we.
• Acknowledge that more help and more resource 
intensity aren’t always 
 ne
eded—   or 
even beneficial. Many

ne
eded—   or 
even beneficial. Many 
of our investment processes include an embedded assump-tion that more is always 
 be
tter—   bi
gger teams, more exper-
tise, greater infrastructure. But natural systems use the appropriate level of resources and energy, not the maxi-mum. Sometimes the appropriate level of complication is high, but often it is low.
• Invest with a goal of fitting form to functions.  Aim for

a clear match of form and function, not the fanciest, most innovative, most clever, or most popular possibility.
By more fully acknowledging the importance of 
resource and energy efficiency in our investments, we can identify the investment equivalent of the duck’s preen oil or the toucan’s bill. We can eliminate needless complexity and focus our energies on areas where the extra effort is needed and beneficial.
We can move from shallow efficiency to deep 
 ef
fec ti
veness.

ef
fec ti
veness.
195612 i-x 1-214 r4pm.indd  47 2/ 19/14  2: 46:25 AM

4 9Transformation 2
From Synthetic to Simple
We have a great new product,” my friend, a financial 
advisor, announced. “It’s a synthetic  ma
rket-  hed
ging secu-
rity, constructed so that if the market goes down, your losses are limited, but if the market goes up, you capture all of the gains.”
Chatting at a coffee break, this conversation seemed

innocent enough, but it came on the heels of the gigan-tic derivatives losses of 2008 and 2009, so everyone’s risk antennae were up. My advisor friend (I’ll call him Joe) fielded every question with grace and confidence and highly technical language. Still, this security clearly sounded too good to be true, so I asked the question I always ask when someone proposes seemingly magical models to me: “When will this not work?”
To his credit, Joe was well informed, and highlighted

two important caveats: first, these mechanics only worked within certain bands of market performance, so if things were extremely bad or extremely good, the construction of the securities’ performance did not hold. Second, these securities could not easily be sold, because once set up for a “
195612 i-x 1-214 r4pm.indd  49 2/ 19/14  2: 46:25 AM

5 0specific time period, they had to run their course, and could not be undone. The idea behind this offering was not a bad one, but it was very specific, managing a particular range of risk for a particular market for a particular time period.
Somehow as we talked, the image of processed cheese

popped into my head. I grew up near Philadelphia, so trust me, I understand the value of Cheez Whiz, especially when properly applied to a steak sandwich or perhaps a soft pret-zel. But everyone knows Cheez Whiz is not exactly the centerpiece of a healthy nutritional plan. In fact, one thing I admire about Cheez Whiz is the “z”—
  th
ere is truth in that 
letter. This product doesn’t even pretend to be actual cheese. We could use a labeling equivalent like this in the invest-ment 
 wo

wo
rld—   fun
dz of fundz, maybe, or  de
rivativz—   so
me 
signal that the product in question is not quite natural.
In the absence of such a label, we can employ the prin-
ciples of nontoxic production.
Nature’s Principle: Nontoxic Production

By now, we’ve all heard about “toxic securities,” the ones that are unsellable, and seem to be worth less than zero. But what is the source of this toxicity? We don’t often think of investing as a manufacturing business, but in fact all invest-ments involve some sort of creation. Therefore, the means of creation are a vital component of a healthy financial sys-tem. If you are manufacturing auto parts and your goal is to have no toxic waste, you need to design that into the process from the very

to design that into the process from the very beginning. The same is true for finance.

fr o m  syNt h e t I C t o  s ImPl e
5
1To address these questions of healthy creation, we have 
nature’s principles of  li
fe‑ 
 fr
iendly chemistry , which empha-
size nontoxic production. The subprinciples in this cat-egory are:
•
 Do 
chemistry in water.
• Bui
ld selectively with a small subset of elements.
• Br
eak down into benign constituents.
At first glance, this principle is a tough one to apply to

social systems like investing: after all, in nature, chemistry is a literal, tangible thing. But even when studying natural systems, the word “chemistry” tends to throw some people off: we are talking about biology, right? So why all of this focus on chemistry and toxicity?
Well, at the molecular level, all that happens in the 
world is 
 ch
emistry—   wh
ether it’s in the forest or in the test

ether it’s in the forest or in the test 
tube. Assembling and combining elements produces a huge range of functions that are important in nature as well as in manufactured 
 pr
oducts—   ch
aracteristics like color, struc-
ture, and strength. So when we think about the concept of nontoxic production, we mean that products in nature are assembled in a way that does not harm life.
Comparing the production processes in nature with

the ones in human factories turns up some startling dif-ferences. There are no solvents in nature, no highly syn-thesized reagents, no dyes made of rare elements. Just as importantly, when natural organisms break down, we are left with benign, simple elements like carbon and nitrogen. There are no toxic dumps in nature.
195612 i-x 1-214 r4pm.indd  51 2/ 19/14  2: 46:25 AM

5 2For example, those amazing colors in peacock feathers? 
They are not colors at all, at least not the way we com-monly think of color. The pigment in those feathers is actu-ally brown. It’s the structure of the feathers that reflects light to display all of those brilliant blues and greens. Small 
 cry
stal-  li
ke structures are arranged to reflect and filter dif-

ferent wavelengths of light. There are no synthetic chemical compositions or artificial dyes required.
1
Some might argue that humans have more complicated 
needs than natural systems (never mind that we are part of nature ourselves). We need to build tall buildings, for example, and how could you do that without steel? Well, spider webs are stronger than steel, with the proteins made completely “in house”—
  in
side the spider. There is no need 
for  tw
o-  th
ousand-   de

for  tw
o-  th
ousand-   de
gree furnaces. This isn’t to deny steel’s 
value to the world, but rather to illustrate that nature pro-duces equally amazing products using a very simple subset of elements in elegant ways.
The subprinciples of healthy production add more 
nuance to this core concept: first, do chemistry in water .

This is the “how” of nontoxic production, and reflects the fact that nature does not have the luxury of dumping syn-thetic reagents into the middle of its processes, nor does it have a warehouse full of synthesized, complex materi-als at its disposal. For example, tiny diatoms are among the most abundant organisms on earth, found almost any-where that there is light and water. By some estimations, the photosynthesis of these simple creatures accounts for over 20 percent of the planet’s oxygen

for over 20 percent of the planet’s oxygen production. One unique feature of diatoms is that their cell walls contain a large

5
3proportion of silica, which keeps their shapes remarkably consistent. When these walls are assembled, it’s through the employment of specific proteins; essentially the diatom creates glass walls internally, with 
 pr
oteins—   no 
need for a 
huge,  en
ergy-   in
tensive furnace.2
If the first subprinciple relates to “how,” the second one 
answers “what”: build selectively with a small subset of

element equal space, equal weight on the chart. But in the reality of the natural world, the elements are anything but evenly distributed. Almost every beginning chemistry stu-dent has memorized the acronym CHON, because the vast bulk of natural organisms’ mass is made up of just four ele-ments: carbon, hydrogen, oxygen, and nitrogen. The next bundle of common elements includes calcium, chlorine, magnesium, potassium, phosphorous, sodium, and sulfur. And after that, the whole alphabet soup of

And after that, the whole alphabet soup of the rest of the periodic

ta
ble—   we
ll, those elements are really pretty rare. 
In the human body, for instance, 96 percent of our mass is made up of oxygen, carbon, hydrogen, and nitrogen.
3
Once any product has been assembled, the next logical 
question is, “what then?” The answer is the subprinciple, break down into benign constituents.  This concept is quite 
specific, demanding that decomposition results in no harm-ful by
-pr
oducts. However, it does not say that there are no

toxic elements along the way. Take cobra venom, for exam-ple, an obviously toxic substance that still manages to be in alignment with life’s principles. The venom is assembled without synthetic reagents, from simple elements, and then it breaks down into benign constituents. In between those 
195612 i-x 1-214 r4pm.indd  53 2/ 19/14  2: 46:25 AM

5 4stages, it performs its intended  pu rpose—   a highly toxic 
purpose (at least for the prey). The venom ensures protec-tion and function for the snake in a spectacularly effective way, but with no toxic elements leftover at the end of the process.
4
When we consider the application of these specific 
scientific ideas to human social settings, two important themes emerge. First, this kind of production is not just 
 si
mple—   it

see the woods in the distance, dozens of types of trees and shrubs and living organisms, it seems miraculous that the ingredient list for that huge variety of life is so short. This is a key subtlety within the second subprinciple: not only is there a small subset of elements, but they are assembled in elegant, even exquisite, ways. It’s like a master pastry chef who can fill a whole bakery with different arrangements of flour, butter, eggs, sugar, and yeast. A little salt here, a little

sugar, and yeast. A little salt here, a little vanilla there, maybe an occasional dash of cardamom or cinnamon, and voilà! Immense variety, produced with a tiny subset of ingredients plus elegant assembly techniques. Compare this vision of a gorgeous organic bakery with a stroll down the

sh
elf-  st
able bakery aisle at the grocery 
store, where each label is less pronounceable than the last, and this abstract life’s principle is suddenly crystal clear.
One misperception we often hold is that something sim-
ple, elegant, and benign is also somehow limited. This is the second vital concept that relates to nontoxic chemistry: 
 li
fe‑ 
 fr
iendly processes are not limiting, or lesser. To be fair, 
many of us have worn scratchy  na
tural-   fib
er shirts or eaten 
leaden  wh

tural-   fib
leaden  wh
ole-  gr
ain muffins. But these shortcomings are 
195612 i-x 1-214 r4pm.indd  54 2/ 19/14  2: 46:25 AM

5
5problems of design and assembly, not shortcomings of nat-ural components. As we can see from the toxicity of cobra’s venom, the strength of spider’s silk, the variety of the for-est, and the elegance of the diatom, 
 li
fe-  fr
iendly chemistry 
does not mean “weak.” It does not mean “plain.” It does mean that we can create variety and function and splendor in a way that is conducive to life, instead of harmful.

We’ve been conditioned to think that limits are inher-
ently bad, that they are something to be transcended, that every barrier should be broken. Janine Benyus notes, “We humans regard limits as a universal dare.”
5 But limits at the 
start of a  pr
ocess—   to 
the number or type of inputs, or to 
the conditions surrounding a problem and its  so
lutions—  
 do 
not necessarily limit the creativity of outputs. In fact, 
Figure  2–  1  Li fe‑  Fr iendly Chemistry: The Honey

Bees process pollen and nectar into an amazing array of products, like honey, wax, and royal 
 je
lly—   a p
erfect illustration of building elegant 
products with a small subset of elements.
195612 i-x 1-214 r4pm.indd  55 2/ 19/14  2: 46:25 AM

5 6limits are often a spur to innovation. Instead of focusing energy on creating new components, all of that attention can be focused on creating different, better outcomes. This concept was highlighted in recent years at the LEGO com-pany, where one element of the organization’s comeback was shrinking the menu of components that new product designers could work with. The smaller, more limited menu turned out to be the inspiration for much better products.

6 
Sometimes the best way to get a terrific out -of- th
e-  box 
a
nswer is to start with a lot of  in
side-  th
e-  box 
constraints.
Translation to Investing
Even if you like spiders and French bakeries, this particu-lar principle might seem irrelevant to the investment realm. What constitutes “chemistry” for finance? More impor-tantly, what would “
 wa
ter-  ba
sed chemistry” or nontoxic 
assembly and disassembly look like?
I found my way through these challenging questions by

starting with the second subprinciple, the “what.” This is the principle that talks about using simple components in elegant ways. When I think back to the story that begins this chapter, the magical 
 ma
rket-  he
dging security, I see

ma
rket-  he
dging security, I see 
a product that is clearly a bit misaligned. This security is really a bundle of other securities, all of them market options that link to various performance scenarios. None of the elements in this security is a primary investment transaction or relationship. It’s like a financial Twinkie, 
195612 i-x 1-214 r4pm.indd  56 2/ 19/14  2: 46:25 AM

5
7one synthetic ingredient layered on top of another to form what appears to be a coherent whole.
Now, I have been known to enjoy the occasional 
Twinkie, but the central question behind life’s principles is always “for what purpose?” A Twinkie might provide enjoyment, it might provide caloric intake, but it does not provide true nourishment. So I asked a similar question about the 
 mar
ket-  he
dging security: toward what end? What

ket-  he
dging security: toward what end? What 
is the purpose of this creation? What is its function?
This proved to be a helpful starting point. The hedg-

ing security was designed to provide a sense of comfort, because it would cushion some potential downside in market performance. And it also provided a sense of control, because the purchaser could feel agency, having taken action to protect her capital and perhaps even to grow it. But the key word in those sentences is “sense”: a Twinkie provides a sense of indulgence, but it does not provide true nourishment. Likewise, this security provided a sense of comfort and control, but it did not do

a sense of comfort and control, but it did not do much to address real underlying risk and uncertainty for the investor.

Thinking through that particular subprinciple of “what” 
led me back to the other principles of nontoxic production. I was especially struggling with the idea of 
 wa
ter-  ba
sed

wa
ter-  ba
sed 
chemistry: What is the equivalent of water in finance? When we think through the benefits of water as a chemi-cal base, we see that it offers several characteristics: first, it is flexible. Sometimes water is a key catalyst in a chemical reaction, but other times it is a neutral carrier for other ele-ments. And second, water itself is bountiful and nontoxic. 
195612 i-x 1-214 r4pm.indd  57 2/ 19/14  2: 46:25 AM

5 8In most environments, it is present before any chemistry takes place and it is there long after, too.
Considering these characteristics, I believe that the

“water” in finance is community, connection to the world. When we start and end our investing with community, there is a continuity of chemistry throughout the process, a link that binds investing to activity in society. Sometimes people serve as a vital catalyst in our investing process, and sometimes people are more neutral actors, but they are always present.
In contrast, when we start an investment process with

synthetic securities as our ingredients, the only possible output is one that is more and more synthesized, farther and farther from the primary investments that fuel the real economy, that nourish our real communities. People are far away from every stage of this process, and far from its out-puts. The problem is that though people are removed from these synthetic creations , we are still impacted by the out-

comes, the results that echo back in a powerful way onto the real world and the people in it.
When we want to refocus on “
 wa
ter-  ba
sed chemis-

wa
ter-  ba
try,” then, we need to refocus on the nonsynthetic pieces of finance, the direct transactions and primary relationships that form the authentic core of investing. And what pro-vides the supportive, nontoxic environment in which those primary connections occur? Community of people, links between individuals and all of their various needs, contri-butions, and endeavors. This is our water.
Those synthetic creations, the Cheez Whiz and Twink-

ies of finance, are not inherently useless instruments, but 
195612 i-x 1-214 r4pm.indd  58 2/ 19/14  2: 46:25 AM

5
9we have mistaken them for the real thing, for true nourish-ment, for solutions to our deepest needs. What’s essential are the direct connections, the primary transactions that form the core of investing: the “whole foods of finance.” The financial Twinkies need to be around the edges, more 
 ra
re—  no
t at the center of our investment plates. Moving

t at the center of our investment plates. Moving 
closer to the primary, unsynthesized forms of investing automatically brings us into closer alignment with life’s principles.
Natural Scorecard:  Mo rtgage-   Ba cked Securities
By now, thanks to the financial crisis of 2008, terms like CMO, CDO, and 
 CDO
-  sq
uared have entered into common

use, and everyone seems to understand that many of these creations were ultimately “toxic.” The trouble with this line of thinking is that it is just as simplistic as the one that led us into danger in the first place: financial creations are generally not bad or good, but they all have specific char-acteristics that may solve a certain problem, or may cause a different one. Examining mortgage securities through the lens of nature’s nontoxic principles brings a deeper under-standing of this

When I was first assigned to be a housing analyst in 
the early 1990s, my knowledge of mortgages was mainly drawn from George Bailey’s description in It’s a Wonderful 
Life. When there’s a run on the Bailey Building and Loan, 
George explains that he doesn’t have all of the townspeo-ple’s money back in a safe; it’s been loaned out to their 
195612 i-x 1-214 r4pm.indd  59 2/ 19/14  2: 46:25 AM

6 0friends and neighbors, as mortgages on their homes.7 Turns 
out, this is not such a bad model to have in mind: in its most essential form, a mortgage is a simple, direct transaction, connected to specific people and specific communities.
Before leaping ahead to the current century’s mortgage 
woes, think of a plain old mortgage on a 
 si
ngle-   fa
mily

si
ngle-   fa
mily 
house. In this transaction, you have a house, a buyer, and a lender. Simple elements, connected directly to one another, with a straightforward mechanism that is easy to unwind. This kind of transaction can bring great benefit: before the mortgage market was developed, you’d have to save up for years and years, or be born into some serious financial luck, to be able to afford a home purchase.
When it comes to disassembly of a conventional mort-

gage, it’s pretty simple. Take apart a traditional mortgage and you are left with those same essential 
 co
mponents—   a 
ho
use, a buyer, and a  le
nder—   an
d they can all separate and 
go on to be reconfigured in different combinations. Impor-tantly, it doesn’t matter if these elements separate for happy reasons, like the loan being paid off, or unhappy reasons, like the borrower being unable to repay. Regardless of circumstance, the components are benign.

Compare this sort of simple mortgage against the “
 li
fe- 
 fr
iendly chemistry” principles:
• Is 
there “chemistry in water”? Are the components 
all connected in community? A direct transaction, by definition, is tied to specific people and places, so yes.
195612 i-x 1-214 r4pm.indd  60 2/ 19/14  2: 46:25 AM

6
1• Is the product built selectively, with a small subset o
f elements? Yes, a straightforward,  ol
d-  sc
hool 
loan only needs a lender, borrower, and asset.
• Does 
the product break down into benign con‑
stituents? At the end of its life, the loan compo-nents can easily separate and go on to other uses, so yes, the breakdown process is benign.
Single, simple mortgages, then, are pretty well aligned 
with principles of 
 li
fe-  fr

 li
fe-  fr
iendly creation: they’d earn a grade 
of A-mi
nus, or perhaps B -pl
us.
Now, let’s look at a more modern version of mortgage

finance, the collateralized mortgage obligation (CMO), or its broader financial category, the collateralized debt obliga-tion (CDO). There is a lot of complexity in some of these instruments, but at its heart, all that a CDO does is bun-dle together loans in order to rearrange the pieces and resell them. In certain circumstances, this kind of arrangement could be very useful: say you are worried about the economy in one geographic area, but you know that a big employer is thriving the next

you know that a big employer is thriving the next county over. Or say that you’ve already made a lot of

hi
gh-  ri
sk loans and you want to balance that 
out with some  lo
wer-  ri
sk lending. A CMO allows you to mix 
geographies, borrowers, and loan types in ways that should enable an investor to pick and choose their exposures. This kind of arrangement could also benefit borrowers, since it allows their risk to be mixed together with others, which should generally make their cost to borrow lower.
Though a CMO is more complicated than a simple

Though a CMO is more complicated than a simple 
195612 i-x 1-214 r4pm.indd  61 2/ 19/14  2: 46:25 AM

6 2mortgage, it can certainly serve some useful purpose. So how is it that this whole category came to be associated with tox-icity? Here is a condensed history of what happened to this market in the years heading up to the 2008 financial crisis:
• We
 sa
w a ra
pid in
crease in th
e vo
lume of primary 
 ac
tivity —  th
e aggregate value of those plain old home

e aggregate value of those plain old home 
mortgages in the United States grew from $1.5 trillion in the beginning of 1986 to $11.1 trillion at the end of 2007, an increase of over sevenfold.
8
• The nature of primary activity , those underlying 
loans, was changing at the same time: in 2006, over 23 per-cent of all mortgages originated were subprime, compared with levels of under 10 percent before the 
 mi
d-  00
s bubble.9
• During that sa me pe riod, th e ag gregate le vel of

securitizations was increased . Mortgage securitizations 
increased even more than underlying mortgage  ac
tivity, 
from $410 billion to $6.4 trillion, an increase of over 
 fif
teen-   fo
ld (roughly twice as fast as the underlying mort-
gage activity). Note that this is the total, cumulative level of securitizations, not new issues, and not notional value.
• Mortgage
 se
curitizations too
k on new 
and bigger

se
k on new 
and bigger 
forms during this period too: at the peak, issuance of new ABS, MBS, and CDO instruments was almost $600 billion in just one quarter (2Q2007).
10
• Synthetic CD Os pr ovided ye t an other ex tension and 
abstraction  of activity. These securities are essentially a 
bet on the performance of other mortgage  se
curities—  
 th
eir value is determined by payment streams on credit 
default swaps, not from payment streams on loans related

6
3to tangible assets. They are an abstraction of a derivative, related to (but far removed from) actual houses, people, or primary mortgages.
11
During a short period of time, then, several layers of

changes were piled on top of one another: first, primary mortgage activity increased in volume and decreased in quality; second, processing of that primary activity into securitizations increased in both volume and complexity; and third, new synthetic products were created on top of those processed securities. All three layers present prob-lems, and each layer shows less and less alignment with the principles of nontoxic production.
A plain old mortgage was pretty well aligned with the

concept of nontoxicity, but now compare the final layer of financial creation, a synthetic CDO, against principles of 
 li
fe-  fr
iendly production:
• Is there “chemistry in water”? Are the components 
all connected in community? The whole point of a CDO is to disconnect the components of specific borrowers, assets, and places from one another, in the hopes of reduc-ing 
 ri
sk—  an
d for synthetics this is all the more true. So, the 
answer is no.

• Is the product built selectively, with a small subset of 
elements? The CDO takes all of the basic elements of indi-vidual loans, adds them together, and rearranges them in a purely manufactured way. The synthetic takes this one step further, creating artificial ways to bet on already packaged bundles of securities. No again.
195612 i-x 1-214 r4pm.indd  63 2/ 19/14  2: 46:25 AM

6 4• Does the product break down into benign constitu‑
ents? Because the CDO has rearranged all of the pieces, and

then the synthetic has abstracted them even further, these securities are hard to deconstruct. The owner of a CDO effectively owns a little piece of lots and lots of loans, and the owner of a synthetic only owns pieces of credit protec-tion payments, so the breakdown process for any one of these securities is inherently difficult and incomplete.
Synthetic securities began as specialized complements

to our basic investing diet, used for unusual circumstances and for particular purposes. In this very specific context, their form might have fit function, even if the composition process was not exactly 
 li
fe-  fr
iendly. But we moved these 
sorts of securities to the center of our investing plates, which pulled a large portion of our financial activity out of alignment with life’s principles. By doing so, we needlessly made mortgage financing toxic, no longer conducive to life.

This analysis does not mean there is no role for CDOs 
or other securitized products in the world, but it does show that there are limits for such products. Once those limits are surpassed, risks are magnified instead of diminished. A rare Twinkie within a mainly 
 ka
le-  an
d-  qu
inoa diet might 
be great, but an  al
l-  Tw
inkie approach to nutrition is peril-

l-  Tw
ous. The existence of processed securities is not a problem, but their rampant and unnecessary growth facilitated much more investment trauma than could have ever been deliv-ered by organizations like the Bailey Savings and Loan, no matter how many defaults there were in Bedford Falls.
195612 i-x 1-214 r4pm.indd  64 2/ 19/14  2: 46:25 AM

6
5Evolution
Contrary to the mortgage finance example, there is plenty of evidence that less synthesized forms of investing and cre-ation are thriving. For example, there is active discussion in angel investing communities about how to fund “nor-mal growth” companies, those whose business prospects are solid, but where the needs for funding are modest and the complications of selling (and buying) equity are unnec-essary. Equity investing in a small start
-up

-up 
company is 
often a painful process for all concerned, with lots of legal paperwork, expense, and sometimes contentious negotia-tions between investor and investee. This is a tough way to start a constructive business relationship! For companies where plain vanilla loans are appropriate instead of equity, the basic agreements can often fit on one sheet of paper, and the main terms to negotiate are just time and 
 pr
ice—   a 
si
mple set of parameters.

pr
ice—   a 
si
Simpler forms of consumer banking also seem to be see-
ing a revival. One of the most popular programs of Green America in recent years is their “Break Up with Your 
 Me
ga-  Ba
nk” guide, which helps individuals seek out local 
banks and credit unions that might serve their needs bet-ter than a large financial institution.
12 In the United States, 
credit union assets crossed the $1 trillion mark in 2012, and the industry reported record earnings.

13 After several 
waves of bank consolidation throughout the 1990s and 2000s, I found that my account had migrated from a small 
195612 i-x 1-214 r4pm.indd  65 2/ 19/14  2: 46:25 AM

6 6local bank to a big national one, without my ever decid-ing to make that switch. Ultimately, I wanted and needed the service of a smaller institution, and so I switched back to a group with more direct and personal customer 
 co
nnections—   mo
re aligned with  li
fe-  fr
iendly principles.
Similarly, platforms like Kickstarter and Kiva allow for

direct links between investors, supporters, inventors, and small business owners. Different forms of crowd funding, like Mosaic Energy, offer similar potential, though there are still lots of regulatory complexities to be sorted out. In these cases, the platforms also put the decision of how to

invest back in the hands of the actual investor: some ena-ble support in the form of gifts, some in the form of loans, some in the form of product purchase. The forms of sup-port are simpler, which means you don’t need lots of layers of processing between you and your investment.

How can we avoid the “Twinkie portfolio”? As with our other life’s principles, this one offers some clear pathways to progress: instead of just asking about mechanics of an invest-ment or its clever design, begin by asking “to what end?”  If 
the proposition is merely clever, but not serving a vital need, move on. If it is serving that vital need, then ask how. Can

you trace its connection to real products, real people, real communities? Can you identify the simple elements that are elegantly assembled to make it? Can you look ahead and envi-sion a benign, straightforward disassembly process or sale?
195612 i-x 1-214 r4pm.indd  66 2/ 19/14  2: 46:25 AM

6
7Once this set of principles becomes engrained in our 
thinking, we can extend our incorporation of them to other layers of investing. If you are comfortable that a fund’s con-struction aligns with 
 li
fe-  fr
iendly chemistry, what about 
all of its subcomponents? What about its managers? What about their sales processes or the infrastructure of their supporting operations?
I don’t mean to keep harping on Cheez Whiz, but the

analogy is a great one. Once we realize we might want more cheese than cheez in our diet (or better yet, less cheez and more carrots), we naturally start asking, what about the bread? What about the person making the sandwich? What about the city that surrounds the sandwich stand?
As we examine each layer, we get closer and closer to 
deeper, more complete alignment.
We live in a society that values technology, innovation, and 
creativity. Importantly, this “
 li
fe-  fr

 li
fe-  fr
iendly chemistry” concept 
does not need to be at odds with those values. Instead, it reo-rients them, demanding even more elegant, effective solutions.
In an investment context, this means that if we’ve been 
solving a problem with a synthetic solution, we demand an organic one, one that is simpler and yet just as effective. Or better yet, we reexamine the problem to see if it can be solved another 
 wa
y—  pe
rhaps in a way that requires an

wa
y—  pe
rhaps in a way that requires an 
elegant, personal, artisanal approach rather than a product that was designed for ease of manufacture and infinite scal-ability. This might seem harder and less efficient than an “off the shelf” solution, of 
 co
urse—   bu
t were you here in 
2008 and 2009? Is it really harder than that? What was the price of that efficiency?
195612 i-x 1-214 r4pm.indd  67 2/ 19/14  2: 46:25 AM

6 8If we need yield, we might find a few simple stocks or 
bonds that serve that purpose, rather than a complicated 
 CDO
-  ty
pe product. Or we may find a local business that

pe product. Or we may find a local business that 
needs a loan, where we understand the risks and want to support their mission. Or we may ultimately question, why do I need that yield in the first place? Is it enabling some-thing in my life that I truly value, or have I just been told I need it so often that I’ve forgotten to ask why?
Rather than asking, “Can you make me a purple 
Twinkie?” we are asking, “Can you make me a 
 cr
eam-   fil
led,

cr
eam-   fil
led, 
curiously shaped cake without all of these chemicals?” Or maybe even, “Can you make me a salad that is so good I forget I about the cake?” Now that is a worthy challenge!
Sowing Seeds of Nontoxic Investing
Here are some simple ideas that help to start us along the “
 li
fe-  fr
iendly” path:
• Consider the core purpose of any synthetic invest-
ment: Is it performing a function that you really need? Is it performing that function well?

• Simplify . If you are tempted to buy a security that 
claims to manage S&P risk, perhaps that means you really just want less exposure to stocks in the first place. There are usually simpler ways to achieve any given purpose than buying a highly processed investment product.
• Invest with the goal of elegant simplicity , not needless 
complication. Aim for a few investments that are simple, 
195612 i-x 1-214 r4pm.indd  68 2/ 19/14  2: 46:25 AM

6
9suitable, and easily disassembled, rather than a Twinkie portfolio.
By aiming for simple, “organic” forms of investing, 
we can avoid some of the risks of toxicity that are inher-ent in overly processed products. We can eliminate needless synthetic creations and come closer to investing in a con-nected, integrated way.
We can move from processed complexity to elegant 
simplicity.
We can shift from synthetic to organic.

195612 i-x 1-214 r4pm.indd  69 2/ 19/14  2: 46:25 AM

7 1Transformation 3
From Maximized to Optimized
What’s with the share count?” my colleague glanced 
up at me, eyebrows raised skeptically as he looked at my freshly constructed spreadsheet.
“Ummmm
 . . .” 
I frowned at the paper, willing it to 
offer up insight. Alas, it was silent.
“Okay,” he sighed. “This company is growing, right?”“Right!”“It says here they are opening fifty more stores next 
year, right?”
“Right!”“And it costs about two million dollars to open each 
store, right?”

“Right!”“So how are they gonna pay for that?”“Ohhhhh.”“Exactly. They’ll need more funding. So fix the share 
count and then let’s talk.”
This was the exchange between me, a 
 br
and-  ne
w equity 
analyst looking at her first retail company, and one of my colleagues who managed a large 
 gr
owth-   or
iented mutual “
195612 i-x 1-214 r4pm.indd  71 2/ 19/14  2: 46:25 AM

7 2fund. (Yes, the details have been changed to be slightly more polite than the exchange that actually occurred). Luckily, because of this sort of conversation, I learned early on that in order for any endeavor to grow, some form of additional resource is required (in this case, issuing more stock, so that the company had more cash, so that it could pay for the new stores). This is a notion that is completely transparent when we consider growth of a seedling, or a 
 ba
by—   th

ba
by—   th
ey obviously can’t grow without nutrients. But 
when it comes to business and finance, sometimes we like to pretend that we can conjure growth out of thin air, with no resources required beyond our own imaginations.
Growth is not just a wish and a prayer, nor a goal unto 
itself. To be effective, growth needs to be integrated with development.
Nature’s Principle: Integrate Development with Growth

Growth is a deeply embedded assumption in many human endeavors. To balance out this simplistic frame of mind we have nature’s principle, integrate development with

growth. The most important element is that this is an “and” statement: growth and development need to occur hand in hand, not one separate from the other. Think of a sunflower, where the stem can grow several feet in just a couple of weeks. What is unseen, but completely neces-sary, is the root structure of the sunflower, which is grow-ing with just as much fervor down and across the soil, to anchor that stem. And still, we can see examples every year

fr o m  ma xImIz e d  t o  o PtImIz e d
7 3at the end of the season where a giant,  se ed-  la den head just 
proves too much for the infrastructure of the plant, and the whole sunflower topples over, uprooted by its own 
 to
p- 
 he
avy weight. Who wants to be that sunflower? A truly bal-
anced “and” embedded within “development and growth” prevents a brilliant growth spurt from an eventual crash.
The subprinciples of integrate development with 
growth are:
•
 Co

•
 Co
mbine modular and nested components.
• Bui
ld from the bottom up.
•  Se
lf-  or
ganize.
The subprinciples of development and growth give 
important answers to the question of “how.” We could easily envision a plan that integrates development and growth in a highly engineered way, but the first subprinci-ple emphasizes, combine modular and nested components .

The idea is not merely to grow larger, but to grow in ways that are repeatable and that fit together as an organism grows. Consider an 
 oc
topus—   it 
does not have one huge 
 me
ga-  ar
m or eight arms with completely different designs

(though that might make for a cool cartoon character). An octopus has smaller suckers that grow to larger suck-ers, and they’re aligned in regular patterns along each of its limbs, allowing it to grow in a way that is both efficient and effective. In fact, even within each sucker an octopus has modular components: there are three sorts of muscles that all work together to make the sucker function.
1 This is 
what we mean by modular and nested components.

195612 i-x 1-214 r4pm.indd  73 2/ 19/14  2: 46:25 AM

74When growth is approached in that modular way, it is 
easier to envision a system that is built from the bottom 
up. A mangrove island can become a robust structure, but not through fancy preplanned blueprints or 
 to
p-  do
wn engi-

to
p-  do
wn engi-
neering. A single seed sprouts and its roots begin to slow the water around it, which helps to settle more sand and more seeds nearby. Then organisms begin to live among the roots and add organic matter until the sand becomes soil. This system is built from the bottom up , and the growth is 
internally generated; though systems take on energy from the outside, the actual creation happens from the bottom

up, from within. Of course there is value to blueprints and planning, but there is also value to systems that allow for 
 se
lf-  or
ganizing growth. It need not be one or the other.
The classic example of a self organized  system is an ant

colony, where the function of the whole is optimized through the actions of individual members. For example, some indi-vidual ants have more sensitivity to hunger, and they are the first to leave the nest in search of food. If the food is more broadly needed within the colony, other gatherers will soon follow the first ones out to search for nourishment. Com-munication within the system is optimized as well, with scouts leaving positive pheromone trails toward the good food sources and negative

trails toward the good food sources and negative trails when their searches have not borne fruit.

2 There is no ant commander in chief, no strate-
gic plan for the colony sitting on a little underground shelf: all of these individual activities, along with appropriate feed-back loops, enable an optimized total system.
This principle seems easy to apply on the surface. Of 
course growth requires development alongside it, focus on 
195612 i-x 1-214 r4pm.indd  74 2/ 19/14  2: 46:25 AM

7 5the supporting structures that allow expansion to be solid and sustained. But delving into the subprinciples, we find some more intriguing ideas:
First, these principles encourage us to move from a lin-
ear growth/nongrowth 
 mi
nd-  se
t to a more integrated point 
of view . Instead of choosing to invest in development or 
growth, they compel us to invest in both. The first questions

for investors should not be “How fast is this investment growing?” but rather, “ Why is it growing?” and “ How is it 
growing?” In fact, in many situations the most important topic to explore is whether an endeavor can shrink in an elegant, nondisruptive way, returning resources to the envi-ronment when conditions warrant it.
The second embedded concept is a shift from 
 to
p‑ 
 do
wn 
controls to bottom‑up activity . At first this idea might seem

to be just the opposite of the managerial approach taken in many of our traditional (and successful) organizations, where complex business planning exercises and intricate monitoring systems seem prevalent. But a closer examina-tion of this principle shows that the idea is “to create condi-tions that allow components of a system to work toward an enriched system,” and to result in a whole that is more than the sum of the parts.
I confess that my first reaction to this particular idea

was to tick off a list of all of the reasons for a company to refuse to model itself after an ant colony. Aren’t we differ-ent? Aren’t we special? Aren’t we more sophisticated? Upon further reflection, I realized that the very best groups I’ve been associated with actually embrace this notion of 
 se
lf- 
 or
ganization, though few label it as such.
195612 i-x 1-214 r4pm.indd  75 2/ 19/14  2: 46:25 AM

7 6For example, for a number of years, I led one of the larg-
est investment research groups in the  wo
rld—   an 
endeavor 
that was both complex and complicated, to say the least. Thankfully, this role did not entail running around to each analyst telling him what to do that 
 da
y—  an
d if it had,

the results would have been disastrous for all concerned. Instead, the leadership of our group tried to set clear objec-tives, the “what,” and perhaps more importantly, clear guidelines for “how,” in terms of responsibility, collabora-tion, and integrity. Then it was up to each member of our team to figure out how her own work could best contribute to the whole. Once in the early years of my career a com-petitor referred to our research team as “the Borg,” because we seemed to have one giant

“the Borg,” because we seemed to have one giant collective mind. I don’t think he meant it as a compliment, but I thought it was kind of cool (minus the intergalactic warfare, that is). Not too dif-ferent from a beehive, a mycelial network, or, yes, a termite colony.

In order for that sort of bottom
-up 
organization to 
be effective, these principles also emphasize the concept of simple rules to govern each part of the system and to 
guide the development and growth of the whole. Unfortu-nately, within finance, this crucial element seems to be at odds with an ever more complicated maze of regulatory, tax, and 
 ma
rket-  re
lated complexity that grows more and

rket-  re
lated complexity that grows more and 
more weighty every year. When I think of simple rules, I recall the first compliance agreement I ever signed as an employee of a big financial firm. It was a few pages long, presented with great (and appropriate) solemnity, and said, in essence, “I promise not to do anything that goes against 
195612 i-x 1-214 r4pm.indd  76 2/ 19/14  2: 46:25 AM

7 7the interests of our own shareholders.”  Fa st-  fo rward

twenty years, and compliance agreements in financial firms look like phone books: page after page of byzantine “what if” scenarios, backed up by floors full of lawyers who try to monitor activity via endless data reports. There are some good reasons why all that complication has developed, but the net result is often to make participants feel less power and responsibility, not more. The slim documents of old essentially said, “We trust 
 yo
u—  si
gn this so we are offi-

yo
u—  si
cially aligned,” while the current  me
ga-  do
cuments seem to 
say, “We don’t trust you, and you could never really com-prehend everything that’s in 
 he
re—  si
gn this so we can pun-
ish you later.”
When we add these ideas about integrated growth and 
development together, we do not see a recipe for the com-mon “
 co
mmand-   an
d-  co
ntrol” models seen in some of our 
largest organizations, nor do we see a detailed up -fr
ont

ont 
blueprint process like those employed in some of our larg-est structural creations. However, alignment with this set of life’s principles does not mean that our human construc-tions should go without planning or guidance. Instead, these principles remind us of the true function of planning, leadership, and management: planning and leadership are best seen as the process of setting those simple rules that govern a system. 
 Ma
nagement—   wh
ether of an organiza-
tion or an investment  por

tfolio—   is 
best seen as setting in 
place appropriate feedback loops. Those loops can incor-porate new information and assess needs for new or differ-ent resources, thus ensuring that growth and development 
are both supported.
195612 i-x 1-214 r4pm.indd  77 2/ 19/14  2: 46:25 AM

7 8http://www.waldeneffect.org/blog/Wild_honeybee_hives/
Before moving to specific financial examples, it is impor-tant to stop to consider the fundamental idea of growth

as it relates to investing. The assumption that underpins almost all of our products, processes, and procedures is not just that growth is good, but that it is required, our central objective. And if growth is good, more growth must be bet-ter. Fast growth and big growth must be best of all.Figure  3–  1 In tegrate Growth and Development: The Beehive

Wild beehives are a great example of integrating growth with develop-ment: the bees build out the infrastructure of the hive not all at once, but bit by bit, only as much as is needed for the colony’s functioning.
195612 i-x 1-214 r4pm.indd  78 2/ 19/14  2: 46:25 AM

7 9Sometimes this thirst for growth translates to a passion 
for business concepts like “scalability.” But nature does not scale, at least not to an infinite degree. Nature replicates. Nature develops. Unlimited growth in investing is thought to be nirvana, but unchecked growth in nature is, quite lit-erally, disease. It’s cancer.
This mismatch between growth in nature and growth

in finance is worth serious consideration. And again, it cir-cles around to the core concepts of context and connection .

As we’ve already discovered, it’s been increasingly common to disconnect financial activity from reality, and yet, at the end of the day, there are still physical limits to growth. These limits are increasingly obvious on a planetary level, but it’s easier to think of a simple natural example like a pumpkin. If you want to eat the pumpkin, you aim for the smallest, sweetest varieties: trust me, growing them big-ger just makes for stringy, watery pumpkin pies. But if you want to win the 
 pu

pu
mpkin-   boa
t contest in Damariscotta, 
Maine, you want the biggest, strongest, lightest vegetable possible. Different contexts, different approaches. And yet when it comes to investing, usually we settle for feeble dis-tinctions by referencing financial 
 ri
sk–  re
turn  tr
ade-  of
fs, 
ignoring all of the other vital dimensions of growth, meas-urement, and success.
Indeed, it is rare for an investment policy statement to

not include the word “growth.” Even in our philanthropic organizations, it is unusual to see a plan for shrinking assets over time, though the entire premise of a charitable foun-dation’s existence is to give money away. Of course, one reason that many of us invest is (at least in 
 pa
rt—  an
d often 
195612 i-x 1-214 r4pm.indd  79 2/ 19/14  2: 46:25 AM

8 0in large part) to grow our own resources. But it is helpful to pause to return to the central question of biomimicry, the central question of life: “ Toward what end? What is

the purpose?” Related to this is the question we usually skip, “Growth of what?” Without thinking, we usually give our growth targets in dollars or percentage points, but there are many other dimensions to consider. We could aim for growth of community, or growth of supportive infra-structure, or growth of tangible asset values, or growth of personal fulfillment. At the very least, we could root for growth of 
 lo
ng-  te
rm economic value rather than growth in 
reported earnings per share.

After the what, we need to consider why. Why do we 
want growth, whether it’s of dollars or apple trees or joy? Is it to fuel consumption? Is it to build up security for uncer-tain times? It is to provide for future generations? Is it sim-ply to “win”? These could all be legitimate reasons under certain circumstances, but they are different reasons, and

they point to different pathways to guide us from here to there. Perhaps most importantly, they also point to different sorts of development that might be needed along the way.
Finally, we need to ask not just how much , but how? 
Almost every endeavor offers the chance to maximize 
 sh
ort- 
 te
rm growth in an inefficient, wasteful manner. But every

good businessperson recognizes that this approach is just hurting his own enterprise; a much more interesting question is, can growth be achieved in a way that is not just sustain-able, but regenerative? This is perhaps the biggest question for the world economies, too: Can we fuel healthy standards 
195612 i-x 1-214 r4pm.indd  80 2/ 19/14  2: 46:25 AM

8 1of living for all, in a way that uses fewer physical resources, instead of more?
A mechanized, 
 on
e-  si
ze-  fit
s- 
 al
l approach to growth 
maximization might be efficient, but it is decidedly not effec-tive. What we need is growth combined with 
 de
velopment—  
 op
timized, not maximized.  Mu
lti-  di
mensional growth, not 
just “bigger.”
Natural Scorecard:  Hi gh-  Fr equency Trading
 High-   frequency trading provides a fascinating case study

f
or the principles of growth and development. This seg-
ment of finance, and its acronym, “HFT,” is beginning to be spoken of with the same ominous overtones as CDOs, as the activity of these firms has been blamed for several “flash crash” events as well as for boosting overall mar-ket volatility. In light of these events, to simply declare that 
 hi
gh-  fr
equency  tr
ading is “bad” might feel satisfying, but

ading is “bad” might feel satisfying, but 
it is not an intellectually rigorous statement. And all of us would recognize that some level of market making, whether in stocks or potatoes or time exchange, is part of a healthy, ongoing economic ecosystem. Examining 
 hi
gh-  fr
equency 
trading through the lens of “integrate growth and develop-ment” provides a more nuanced understanding.
First, a clear definition is in order: 
 hi
gh-  fr
equency trad-

hi
gh-  fr
ing is not the same as market making, and it is not the same as “the” market. At its core, a 
 hi
gh-  fr
equency trading firm 
does the same thing that dozens of others do: it matches 
195612 i-x 1-214 r4pm.indd  81 2/ 19/14  2: 46:25 AM

8 2buy and sell orders on securities, in this case via electronic trading platforms. And, as the name implies, it does so very, very fast. HFTs often complete transactions in milli-seconds or even microseconds. (A microsecond is a millionth of a second; it takes several hundred 
 mi
lliseconds—   th
ree 
hundred thousand  mi
croseconds—   to 
blink your eye.) In

blink your eye.) In 
addition to acting as traders for others, many HFT firms also trade for themselves, using quantitative trading algo-rithms for their own purposes.
I call this the “spin class” approach to trading: if you

want a really efficient workout, when the perky instructor at the front yells, “Faster!” you obey, pedaling until your legs are just a blur, they are moving so fast. Likewise, when markets seemed to require more liquidity, participants nat-urally called out, “Faster!” and the 
 hi
gh-  fr
equency trading 
firms obliged, cranking up volumes and speed until trans-actions were just a blur, moving so fast that they are liter-ally unmatchable by human eyes, let alone human brains and human judgment.

But the thing about spin class is, it ends. We are not 
meant to stay at peak activity levels forever, and once a workout is over, there is always time to recover. Again, this reflects a cycle of integrated development and growth. With the market, though, spin class has become eternal. Policies and practices that made sense in times of extreme duress were codified so that they became the 
 no
rm—   a p
ermanent

no
rm—   a p
ermanent 
peak workout in trading volumes. This constant focus on speed and growth might be a clever mechanical trick, but it is not a characteristic of a healthy ecosystem.
Yet when it comes to growth, few sectors of finance can 
195612 i-x 1-214 r4pm.indd  82 2/ 19/14  2: 46:25 AM

8 3compare with the record growth of HFT in the  mi d-  20 00s.

In 2005, this activity represented about 21 percent of total market volume, but by 2009, this figure was a whopping 61 percent. Overall market volume had also grown signifi-cantly during this period, from about four billion shares of U.S. stocks traded daily to just under ten billion, but if you look closely at those numbers you’ll see that most of that growth (about 90 percent) was accounted for by the growth in HFT.
3 If we picture the market as a tree, and

3 If we picture the market as a tree, and 
all of the different trading firms as branches, the HFT branches grew all out of proportion to the rest of the tree during this period. We’ve all seen weird, lopsided growth spurts like this in nature, and it’s easy to see how they are resolved: either the other parts of the tree have to develop to catch up with the runaway limbs, or eventually, some-thing will break and crash to the ground. The whole tree could even be destroyed.

When we compare the basic activity of 
 hi
gh-  fr
equency 
trading against the “integrate growth and development” principles, here’s what we find:
• Does HFT combine modular and nested components 
in its construction? Each trade is an individual action, and each piece of a trading algorithm is also discrete. When these pieces are nested together, that’s when the whole firm and whole algorithmic approach are revealed. So, there is some evidence of using modular and nested components.

• Does HFT build from the bottom up? These firms do 
not begin by examining the entire market and then carv-ing off slices where they’ll participate. Each trade, each 
195612 i-x 1-214 r4pm.indd  83 2/ 19/14  2: 46:25 AM

8 4security, each exchange presents individual opportunities, and these aggregate to form overall activity. So, there is some evidence of building from the bottom up.
• Does HFT demonstrate 
 se
lf‑ 
 or
ganizing principles?

se
lf‑ 
 or
ganizing principles? 
The concept behind a trading algorithm is to create sim-ple rules to guide activity (of course, the simple rules are wrapped in elegant, perhaps complicated, code). And the business concept behind most HFTs is that gathering up tiny profits over and over again creates good business results. In theory, at least, this idea is not so far from life’s principle of 
 se
lf-  or
ganization.
The answer to all of these questions is “sort of.” HFT in

and of itself is not in clear alignment with the natural prin-ciples of growth and development, but it is not obviously misaligned either. A grade of C, maybe C
-pl
us.
But now let’s consider a more systemic view of  hi
gh- 
 fr
equency trading, along with a less benign backdrop: the

“flash crash” of 2010. On May 6, 2010, the Dow plunged over 9 percent in midafternoon, only to recover most of that ground by the close of the day. There have been several smaller, similar events since then, but the 2010 example is the most vivid and the most studied to date.
By 2010, high frequency trading was over half of market

volume, so naturally, when the flash crash was analyzed, activity of these firms was a crucial piece of the analy-sis. The video depictions of trading during the flash crash are especially eerie: they show order routing between the major trading firms, with each firm a node at the edge of 
195612 i-x 1-214 r4pm.indd  84 2/ 19/14  2: 46:25 AM

8 5a big circle.4 At first the flow looks just like a bunch of bees 
flying between nectar sources and beehives, or balls on a playground: dots flying regularly to and from each major node. And then, suddenly, the flow stops. Every once in a while a signal pulses out from one of the hubs into space, but it’s met with silence. No response. When I watch these 
 tr
ade-  flo
w images, I am still oddly shaken. In many market

crises, trading values fall dramatically, but trading volume 
is still very active. Watching these depictions, where activ-ity just stops altogether, is like watching a living organism die.
Explanations for the flash crash are long, multilayered, 
and still subject to some dispute, but consider these facts:
• The
 of
ficial SE
C ex
planation of th
e fla
sh cra
sh ce
nt-

C ex
e fla
sh cra
sh ce
nt-
ers on a single order to sell futures contracts with a value of just over $4 billion. The sell order caused pressure not just on the contracts in question, but on the stocks related to those contracts, and the ripple effects of the resulting vola-tility caused some traders to step back, while other auto-mated programs continued unchecked.
5
• According to th e Ne w Yo rk Sto ck Ex change, pa rt of 
th

th
e problem was a mismatch where systems at the NYSE 
are meant to automatically slow trading during extremely 
volatile times, whereas the systems at some HFT firms are, if anything, designed to speed up as volatility increases.
6
• As part of th e in vestigation pr ocess in 20 10, th e Co m-
modities Futures Trading Commission (CTFC), the equiva-lent of the SEC for commodities trading, created a technology 
195612 i-x 1-214 r4pm.indd  85 2/ 19/14  2: 46:25 AM

8 6advisory committee of quantitative traders and other tech-nological experts. An advisory committee like this had not existed for five 
 ye
ars—   th
e same five years when HFT was 
growing from 20 percent to 60 percent of trading volume.7
• One critique of th e SE C in vestigation is th at th e ti me 
in
crements it used for analysis are too long (the report 
accounts for second -by-se
cond trading activity on that day).

cond trading activity on that day). 
Alternate analytical views favor timing measures of just 
 tw
enty-  fiv
e milliseconds for their analysis. It is hard for our 
analysis to match the pace of trading, even in retrospect, when we have all the time in the world to calculate and consider.
Our goal here is not to decipher or debate the exact

causes of the flash crash, but rather to highlight some clear systemic mismatches, areas where growth was decidedly not aligned with development. Though our assessment of HFT as a single component in the system showed some potential for alignment with life’s principles, this inquiry into the broader trading landscape clearly shows a system that contains seriously misaligned elements. The growth in 
 hi
gh-  fr
equency trading was decidedly not supported by

equency trading was decidedly not supported by 
commensurate development in all of the structures needed for healthy function. There was not growth in the rest of 
the trading market alongside the growth in HFT. There was not development of oversight or technical expertise in 
other parts of the system to appropriately incorporate the rise of HFT. There was not progress in related systems like 
the NYSE’s so that their functions aligned with (or comple-mented) those of 
 hi
gh-  fr

hi
gh-  fr
equency firms.
Comparing the overgrown version of HFT systems with 
195612 i-x 1-214 r4pm.indd  86 2/ 19/14  2: 46:25 AM

8 7the principles of “integrate growth with development,” we find considerably less alignment than before:
• Does HFT combine modular and nested components

in its construction? Though each organization, each proc-ess, and even each trade might be shown to be in partial alignment with these principles, each of them also demon-strates some areas of misalignment. And in this case, when all those pieces of the system are assembled and under duress, the cracks are magnified and the entire system is less aligned than its parts.
• Does HFT build from the bottom up? There was no

way for the structures, systems, processes, or regulations embedded in the individual organisms (other parts of the system) to evolve fast enough to match the growth of 
 hi
gh- 
 fr
equency trading.
• Does HFT demonstrate  se
lf‑ 
 or
The feedback loops were weak and often did not extend beyond the walls of any single participant in the system. Connections between participants extended far beyond counterparties for any given trade, and yet these links were underestimated.

Even the SEC concluded, “May 6 was also an important 
reminder of the interconnectedness of our derivatives and securities markets.”
8 A system lacking in understanding of 
its multilayered connections, lacking in feedback loops that incorporate them effectively, lacking in mechanisms that allow for rapid evolution
 . . . 
 th
is is a system incapable of 
integrating development with growth.
195612 i-x 1-214 r4pm.indd  87 2/ 19/14  2: 46:25 AM

8 8Evolution
Growth discussions are often most feverish when we discuss 
 ea
rly-  st
age ventures, and for good reason: often, without 
rapid growth, these fragile ventures fail. Within this entre-preneurial arena, there are several hopeful developments.
First, the notion of “fail fast” has taken hold in many

new ventures. This idea recognizes the inherent fragility of any new endeavor, and instead of denying that fragility, encourages participants to embrace it, planning for small experiments, quick assessments, and, if need be, graceful endings. The focus is not exactly on failure, but on culti-vating an ability to quickly test, assess, and adapt. Build-ing this concept of modular testing and designing with appropriate feedback loops from the very beginning of an enterprise is a fundamentally

beginning of an enterprise is a fundamentally different starting point from the

tw
entieth-   ce
ntury “deep research, big bet” approach, 
which was in part necessitated by much more  ca
pital-  
 in
tensive businesses. If you failed fast back then, you often 
did not have the resources to adapt and try again.
Second, more attention has been paid to the “develop-
ment” part of development and growth in recent years: dozens of incubators and mentor programs are available for entrepreneurs now, whether they are writing new soft-ware in a loft or training rural 
 he

he
alth-  ca
re workers half a 
world away. The communities that are arising among these incubators, innovation corridors, and entrepreneurial hubs are adding to the diversity, vibrancy, and strength of the overall system. Additionally, there is more attention paid 
195612 i-x 1-214 r4pm.indd  88 2/ 19/14  2: 46:25 AM

8 9to the fundamental capital intensity of  ea rly-  st age busi-
ness models, which often relates to the ongoing  re
source-  
 in
tensity of those same businesses. Growing a software 
business has a fundamentally different set of needs than growing a lumber business, and those differences are becoming better understood by entrepreneurs, managers, customers, and investors.
Most importantly, our definitions of growth and

Most importantly, our definitions of growth and 
growth’s purpose have begun to expand. Alternate, more multidimensional views of prosperity are extending far beyond the narrowness of standard measures like gross domestic product. Measures like the Social Progress Index and gross national happiness are being discussed in the halls of Davos and Harvard Business School,
9 and are 
beginning to address the shortcomings made famous by Robert Kennedy in his 1968 speech:
 . . .  gr

cigarette advertising, and ambulances to clear our highways of carnage. It counts special locks for our doors and the jails for the people who break them. It counts the destruction of the redwood and the loss of our natural wonder in chaotic sprawl. It counts napalm and counts nuclear warheads and armored cars for the police to fight the riots in our cities. It counts Whitman’s rifle and Speck’s knife, and the television programs which glorify violence in order to sell toys to our chil-dren.

violence in order to sell toys to our chil-dren. Yet the gross national product does not allow for the health of our children, the quality of their education or the joy of their play. It does not include the beauty of

9 0our poetry or the strength of our marriages, the intel-ligence of our public debate or the integrity of our pub-lic officials. It measures neither our wit nor our courage, neither our wisdom nor our learning, neither our compassion nor our devotion to our country, it meas-ures everything in short, except that which makes life worthwhile. And it can tell us everything about Amer-ica except why we are proud that we are Americans.
10

10
As our definitions expand, they can more accurately 
reflect true cost and true profit, allowing us to make more thoughtful, complete investment decisions, both as individ-uals and as societies.
Along with the rapid growth in social entrepreneurs,

we are seeing a generation of new businesspeople for whom “double bottom line” and “triple bottom line” are needless fabrications. These servant-leaders take an integrated view from the very beginning, considering growth of impact, growth of scale, and growth of finances in an intertwined, multifaceted way. 
Many of these new entrepreneurs follow in the footsteps

of predecessors like Judy Wicks, owner of the White Dog Café in Philadelphia. Given the huge success of the café, Judy was constantly urged to grow her business through franchis-ing or other physical duplications. But she chose otherwise:
Instead of making business decisions to maximize prof-its, I made decisions to maximize relationships. And in the long run, I believe this was also the reason for our financial sustainability. I had come to realize that we

9 1could measure our success in other ways than grow-ing physically. We could grow by increasing our knowl-edge, expanding our consciousness, deepening our relationships, developing our creativity, building com-munity, and enhancing our natural environment. All this while also increasing our own happiness and 
 we
ll- 
 be
ing, and having more fun.11
This sort of multidimensional growth reflects a more

resilient approach, with multilayered, powerful ben-efits. And importantly, it provides an example of growth that does not rely on constantly increasing use of natural resources. Just the opposite, it helps to regenerate commu-nity ecosystems and natural ecosystems alike.
This breadth of definitions is also echoed in the B
-co
rp

-co
rp 
(benefit corporation) movement, where businesses explic-itly embrace goals that go beyond their financial state-ments, reminding us of the many forms of impact that our enterprises can have. The B
-co
rp “Declaration of Interde-
pendence” reminds us that all of our endeavors have multi-dimensional elements that link to a broader social web, and that acknowledging this connection is the first step toward healthy, 
 lo
ng-  te
rm development. B corps “compete not just

rm development. B corps “compete not just 
to be the best in the world, but to be the best for the world.”12
195612 i-x 1-214 r4pm.indd  91 2/ 19/14  2: 46:25 AM

9 2Pathway to Practice
How can we avoid financial activity that is the equivalent of a 
 ne
ver-  en
ding spin class? The life’s principle “integrate 
growth with development” offers some clear pathways.
Instead of assuming that growth and speed are inher-

ently good, we can pause to question the purpose and nature of those characteristics. Do we need growth in sheer size, or in complexity, or in redundancy? Do we need greater speed, or the ability to modulate speed as condi-tions change? Some of the initial growth in HFT brought benefits to overall market liquidity, at a time when that liquidity was a vital “nutrient” for the market and in short supply. But just as farmers adjust techniques to suit varied soil and weather conditions, we need to

-as
k 
the fundamental question, what is needed here? What is needed now? Maybe the answer is “more,” but the obvious follow
-on 
question is “More what?” And why?
Once we see growth and development as intertwined

concepts, it’s impossible to separate them. The extension of these twin ideas to other sorts of investing is almost una-voidable: If we are looking at a stock, how (and why) is the company planning to grow? Have they thought through all of their “nutrients” and planned for them as carefully as they are planning for financial results? Do conditions war-rant a plan for elegant ways to shrink and return nutrients to the broader system, instead of pushing for 
 re
source-  
 in

re
source-  
 in
tensive ways to grow? If we are looking at municipal 
bonds, they quickly become much more interesting and 
195612 i-x 1-214 r4pm.indd  92 2/ 19/14  2: 46:25 AM

9 3multifaceted than a simple scan of yields to maturity. What is happening in the municipality? Is there a healthy mix of employers, citizens, infrastructure? Is the bond based on one giant 
 me
ga-  de
velopment, without other community 
supports around it?
As we extend the application of this growth and develop-
ment principle, we can move from a  mi
nd-  se
t of “either/or” 
to one of “and,” from unidimensional to multidimensional.

Sowing Seeds of Integrated Growth and Development
Here are some fundamental considerations to help us move toward balanced, integrated growth and development:
• Reexamine the fundamental purpose of growth. 
Growth in what? In what way? Over what time period? With what characteristics? Toward what purpose? Try to avoid the automatic “more is better” presumption.
• Balance investments in growth with investments in

development. This is helpful on a micro level, as we look at individual investment decisions, and on a macro level, as we consider our overarching purpose in investing. Con-stantly ask, where do we need to add resources to support the type of growth that we seek?
• Accept that spin class is meant to end.  When we find 
ourselves in investment discussions where the premise is 
 ne
ver-  en
ding, effortless growth, recognize that that premise 
is  fic
tion—   un

is  fic
tion—   un
sustainable, unhealthy, or both. How can we 
develop systems that slow, stop growing, or shrink in elegant 
195612 i-x 1-214 r4pm.indd  93 2/ 19/14  2: 46:25 AM

9 4ways? At the very least, how can we focus on endeavors that can grow output or outcomes in ways that do not grow in physical resource intensity at the same time?
We can invest in multiple dimensions simultaneously, 
redeploying current resources to build up supports for the future, instead of harvesting everything in sight for cur-rent use.
We can consider growth and development more broadly 
and fully.

and fully.
We can plan for graceful shrinking, conserving and recy-
cling resources for other times and other endeavors.
We can move from a framework of maximization to 
one of optimization.
195612 i-x 1-214 r4pm.indd  94 2/ 19/14  2: 46:25 AM

9 5Transformation 4
From Disconnected to Reconnected
Over the past twenty years, I’ve had the joy of traveling 
to more than twenty countries with Habitat for Human-ity, offering manual labor to assist local homeowners as they constructed their houses. On one of my early trips to Africa, the leader of the local Habitat group showed us the storeroom, which was just a small shed with tools and a few bags of cement. I was 
 con
fused—   wh
ere were all the

con
fused—   wh
ere were all the 
other building materials? Having been an analyst covering the 
 ho
me-  bu
ilding industry in the United States, I was used 
to seeing big stockpiles of materials near any building site.
Soon enough, I realized where the materials were: they 
were all around us. In the coming days, we took an oxcart down to the riverbank to shovel sand, which we then sifted by hand before mixing into mortar. We walked to the pump down the road to gather water in big, 
 te

te
n-  gal
lon 
containers, many times each day. We dug clay from the very spot where the house was going to be located, shaping it into bricks for the walls. We went out to the woods to cut lumber for the roof framing. Aside from those bags of 
195612 i-x 1-214 r4pm.indd  95 2/ 19/14  2: 46:25 AM

9 6cement, a handful of nails, and galvanized metal sheets for the roof, the materials were all hyperlocal.
Even more importantly, the entire community was

Even more importantly, the entire community was 
involved in the building process. Extended family, friends, and neighbors all helped on the jobsite. Some provided food and shelter for visitors. Others provided moral support, stop-ping by to cheer on the work and to comment on progress. The new house was not just situated within the community; its very construction was a community 
 ac
tivity—   co
mpletely 
locally attuned. A community investment.

Nature’s Principle: Be Locally Attuned and Responsive
Sometimes I think the challenges of our current financial systems can be traced to the early days of space exploration, or perhaps the original Star Trek series. These 
 mod
ern-  da
y

mod
ern-  da
y 
versions of “the final frontier” reinvigorated our zest for stretching and exploring, a concept that has captivated humans for centuries. They exemplified a noble form of exploration, worthy of serious dedication, resources, and sacrifice. They reminded an entire society of the joy of dis-covery, of stretching physical boundaries in addition to intellectual boundaries and technological boundaries.
In many ways, however, our notion of exploration is

curiously limited. We often tend to take a tourist’s view, focusing on what we can bring back from our travels, whether that be greater insights, beautiful photos, goofy T
-sh
irts, new language skills, or moon rocks. In a busi-
ness and investment context, there is a similar limitation: 
195612 i-x 1-214 r4pm.indd  96 2/ 19/14  2: 46:25 AM

fr o m  d IsCoN NeCt e d  t o  reCoN NeCt e d
9 7we often focus on what can be transacted across great dis-tances, rather than on what can be connected. With the click of a button I can buy stocks in Hong Kong, order clothes from London, or book a plane ticket to India, though none of those activities mean that I’ve got any real relationships in those places. Our essential notion of going afar seems inextricably linked to exchange and to our own return, rather than creating ongoing connection.

After a prolonged, intense period of globalization, the idea 
of being “locally attuned” might sound 
 qu
aint—   so
mething 
you do on the weekends at the farmers’ market, before stock-ing up at Target, or jetting off to Monday’s business meeting three thousand miles away. However, the natural principles of being locally attuned are not quaint, and they are not focused on a simple notion of physical proximity; they encompass a more complete concept of life in context .

The subprinciples of “be locally attuned and respon‑
sive” are:
•
 Use 
readily available materials and energy.
• Cu
ltivate cooperative relationships.
• Le
verage cyclic processes.
• Use 
feedback loops.
Much like the Habitat houses I’ve seen around the 
world, bird nests are great examples of the first subprinciple of life in context: u se readily available materials and energy.

Every backyard explorer has found bird nests made of shredded newspaper, bits of string, and other handy mate-rials, in addition to grasses and twigs. Another illustration 
195612 i-x 1-214 r4pm.indd  97 2/ 19/14  2: 46:25 AM

9 8is the sea urchin, which can regenerate its spines by precipi-tating calcite that is already present in the ocean.
1 As part 
of living in context, natural organisms constantly build with abundant, accessible materials and energy, making use of what’s available in the local context. Sometimes this subprinciple is interpreted as the “free stuff” 
 pr
inciple—  
 us
ing whatever is  th
ere—   bu
t that’s not quite accurate. We

ere—   bu
t that’s not quite accurate. We 
see nature using freely available materials, but they aren’t 
literally free. When a bird is collecting twigs or fluff for her nest, there is a big expense of energy involved, as well as some level of risk. Those are costly elements in bird land, anything but free.
Being locally attuned is not limited to materials; it also 
applies to local relationships. Nature offers plenty of exam-ples to illustrate the second subprinciple, cultivate coopera‑

and certain sorts of sea anemones. The anemone has sting-ing tentacles, and this keeps most other organisms away. But the clownfish has a protective mucus coating, so it can live with the anemone, sheltered by those same tentacles. In turn, the clownfish cleans food debris around the anemone and scares away the anemone’s main predator, the butterfly fish. New research also shows that the quick motions of the clownfish bring extra oxygen to the anemone at nighttime, when oxygen levels are

2 It’s easy to human-
ize or romanticize these kinds of relationships, as many an animated movie has shown us. However, these cooperative connections work not because of sentiment, but because the exchange provides real value for both parties.
Living in context also involves being in sync with local 
195612 i-x 1-214 r4pm.indd  98 2/ 19/14  2: 46:25 AM

9 9cycles, and capitalizing on those cycles to support life. This third subprinciple, leverage cyclic processes, can be

observed in the amazing Namib beetle, which thrives in the desert. The beetle takes advantage of the fog that sweeps over the sand dunes at dawn (a cyclic process). When the fog comes, the beetle raises its shell up so that the water condenses on the upturned surface. The shell has bumps that attract water at the tips and channels that then guide the droplets right into the beetle’s mouth.
3
Finally, it’s important to note that living in context is

inherently a dynamic process. To continue to thrive over time, it’s vital to use feedback loops and information flows.

For example, you might have seen those cute meerkats on television in recent years. Well, in addition to being fasci-nating reality stars, the meerkats are tremendous users of feedback loops. These animals eat a lot of scorpions, and as you might imagine, that’s a tricky proposition. Adult meerkats have some immunity to scorpion venom, but if you’re a young meerkat, it’s still important that you learn how to eat a scorpion without being stung. The adults are great teachers here: first they

The adults are great teachers here: first they bring the little meerkats dead scorpions for dinner with the tails bitten off, then they bring live scorpions without tails, then eventually the full live scorpions, stingers and all.

4 The little meerkats learn 
through this iterative instruction, with all of the feedback loops the lessons provide.
There are three crucial components to effective feed-
back loops. First you need the 
 si
gnal—   th
e information 
flow. Second, you need a  re
ceptor—   th
e information needs 
to be received in an accurate and useable form. And finally, 
195612 i-x 1-214 r4pm.indd  99 2/ 19/14  2: 46:25 AM

1 0
0you need an appropriate  re sponse—   no t just any reaction, 
but an appropriate one. All three of these components need 
to align, as they do for the young meerkats.
When we translate the natural principles of being locally 
attuned to a social context, there are a few vital themes to consider. First is the importance of context . These prin-

ciples talk about fitting in to our local environments, but more than that, they require connecting and integrating with those local systems. To thrive in any context we need local inputs, local relationships, and local feedback loops. Anyone who’s worked or lived in a group setting can easily see these layers: think of the high school cafeteria. It’s not too hard to fit in on a basic level, to find a spot in the lunch-room where you are nourished and don’t disrupt the rest of the system. But

and don’t disrupt the rest of the system. But to find your favorite items in the cafeteria line, to have a table of friends to join, to change plans for tomorrow based on conversations and new offerings from the lunch

la
dies—   th
at is real integration, life in context.
The second major theme is one of cooperation and 
connection . To be locally attuned means to be locally

connected, and those relationships all require some level of cooperation. Sometimes it is tempting for humans to emphasize competition, and there are times when those dynamics are relevant. But because cooperation is already so embedded in our lives, we tend to underestimate its importance. Even as I type this, I am surrounded by coop-eration in both human and systemic forms. The power cord to my computer is providing energy in electron form. The tomato bush on my patio is providing energy in

tomato bush on my patio is providing energy in the form of nourishment. Perhaps most importantly, the vast

1 0 1network of family and friends and colleagues surrounding me is providing all sorts of different support. And in turn, I am supporting all of these elements: I pay my electric bill, I water the tomato plant and sing happy songs to it, I sup-port family and friends and colleagues in both tangible and intangible ways.
Sure, I have ongoing debates, disagreements, and cer-

tain kinds of competition every single day in my investment work. And I may on occasion swoop in to secure a prime Beacon Hill parking spot ahead of other seekers. But these moments of competition are all embedded 
 in
—  an
d enabled 
 by
—  a h
uge support system that is intensely cooperative. 
The cooperative system dwarfs the competitive one; it’s just quieter, so we don’t always focus on it.
Finally, we need to consider that being locally attuned

ing feedback loops require accurate signals, effective sen-sors, and appropriate response. In some ways, it seems our human feedback loops are surely becoming more efficient: we are constantly presented with more data, quicker news flow, and easier response mechanisms. But we don’t need to rely on technology. The same sort of dynamic process is embedded in procedures like New England town meet-ings, where open discussion provides a naturally flexible and evolving set of inputs for governance.

and evolving set of inputs for governance. Anyone who’s gone to such a meeting can attest that they are not always speedy, but they are certainly locally attuned.

1 0
2Translation to Investing

1 0
Investing constantly presents chances to create attuned and responsive processes, though we don’t always succeed. Take the simple investment example of quarterly earnings releases. In theory, this could be an example of a proc-ess that is well aligned with the principles of being locally attuned and responsive. Compiling the results mainly http://cat.inist.fr/?aModele=afficheN&cpsidt=21520122; http://www.pbs.org/wgbh/nova/nature/
 wa
ggle-   da

wa
ggle-   da
nce.html ; http://www.nbb.cornell.edu/seeleypub 
.shtmlFigure  4–  1 Lo cally Attuned: The Waggle Dance
Honeybee dances are part of a complex, ongoing communications stream, constantly updating and changing as new information is received and conditions shift within the hive and in the exterior environment.
195612 i-x 1-214 r4pm.indd  10 2 2/ 19/14  2: 46:25 AM

1 0 3consists of using facts and figures already at  ha nd—   re adily 
available materials. And the intention is for investors to better understand what’s happening at the 
 co
mpany—  
 cu
ltivating cooperative relationships. The activity happens 
every quarter, so it’s clearly a cyclic process. The resulting conversations and changes in security prices could provide useful feedback loops.
Examining one particular company helps to bridge

Examining one particular company helps to bridge 
from this theoretically aligned process to the reality of lived experience. When I started covering General Electric in the early 1990s, the press release each quarter consisted of a half page of 
 nu
mbers—   re
venues, net income, earnings 
per share, and share  co
unt—   an
d a brief comment on per-
formance from  th
en-  CE
O Jack Welch. After some time a

en-  CE
O Jack Welch. After some time a 
third section was added, including operating summaries for each big division of the company. On days when earn-ings reports were due, GE analysts all over the world would hover by their fax machines, hoping to be among the first to interpret the results.
These days the quarterly earnings releases from GE

(and all other public companies) have ballooned: the lat-est basic GE earnings report is eleven pages of small print, and the supplemental data packet is 
 th
irty-  si
x pages long. 
These documents are available instantly to anyone with an Internet connection, and are accompanied by detailed slide presentations and a long, recorded conference call.
5 Every

5 Every 
possible fact and figure is compiled, under the widely held (and legally enforced) notion that more is better, and that the volume of disclosure is somehow related to the qual-ity of a business. What started as a quick, simple feedback 
195612 i-x 1-214 r4pm.indd  10 3 2/ 19/14  2: 46:25 AM

1 0
4loop has taken on weight and complication that may not serve its intended purpose. A thorough analyst has to spend hours and hours to understand just one set of reports like this from one large company, diverting all of that time and energy from other research that might be longer term or more creative in nature.
At the same time that input volume has skyrocketed,

the response mechanisms in investment feedback loops have become much quicker and more automated. Instead of walking over to the trading desk or calling a broker to place an order, you can buy or sell stocks with the click of a button. Even quicker, you can set up trading programs with simple flags so that if phrases like “lowered guidance” or “weak margins” appear in a press release, a stock is automatically sold, without any human intervention.

So, our inputs are greater, processing is faster, and 
responses are easier. This sounds like great progress in all three areas of investment feedback loops. Quite the con-trary. Volume, speed, and ease are not what make for effective feedback loops. In all of our endeavors, including investing, we need relevant information, effective process-ing, and appropriate response. Instead of “more, faster, easier” we need “relevant, effective, appropriate.”
Natural Scorecard: Global Commodities Markets

When we think about “life in context” for our ever more global financial markets, it’s clearly important to define that context. What does “local” mean if your business 
195612 i-x 1-214 r4pm.indd  10 4 2/ 19/14  2: 46:25 AM

1 0 5crosses international borders every day? Commodities mar-kets are a curious hybrid, simultaneously local and global: the physical assets are often produced in very concentrated regions (think of aluminum smelters or orange groves), but their distribution covers a much wider area, and their cor-responding financial instruments and markets are among the most global of all securities.
Commodities markets have served some of the same

Commodities markets have served some of the same 
purposes of paper currency over the longer term; both have allowed exchange across much greater distances than would be possible if we were hauling actual tons of alu-minum to and fro. This is a huge benefit, especially if, say, you run a large baking company and you don’t want your business to be subject to the whims of 
 sh
ort-  te
rm changes 
in one area’s wheat pricing.
This is what I would call the “local” version of commod-
ities  ma

products being traded in the course of their own endeavors. Simply speaking, these participants are known as commer-cial traders. In this context, commercial is the equivalent of local: even though the activity might span great geographic distances, it is a directly connected system, where users and producers of the commodity are the ones engaged in the market. In biological terms this might be analogous to a migratory bird, like the alpine swift. These tiny birds breed in Europe but they

swift. These tiny birds breed in Europe but they winter thousands of miles away in west Africa, where the swifts stay aloft for six months at a time.

6 
The “native habitat” of this bird crisscrosses thousands of miles, but when put together, all of those miles form one coherent, connected system.
195612 i-x 1-214 r4pm.indd  10 5 2/ 19/14  2: 46:25 AM

1 0
6Commercial commodity participants made up the bulk 
of commodities trading well into the 1990s. In 1998, physi-cal hedgers (people and organizations that dealt with the actual, tangible commodities) comprised 77 percent of market activity.
7 How do these commercially centered com-
modities markets stack up against the principles of being locally attuned and responsive?
• Does it use readily available materials and energy? A

healthy commodities market requires far less energy than a purely physical market. Instead of moving wheat across the country, your western bushels can be matched up with bushels that are closer to an eastern buyer.
• Does it cultivate cooperative relationships? All mar-
kets are essentially cooperative 
 re
lationships—   ev
ery buyer

re
ery buyer 
needs a seller. We often frame trading activities as hyper-competitive, but while the search for a single great trading “win” might feel competitive, the market itself is inherently a cooperative endeavor.
• Does it leverage cyclic processes ? Effective commodi-

ties markets are designed to do just this, distributing more complete information that should even out the dramatic swings in price that otherwise occur from region to region, from planting to harvest, from year to year.
• Use feedback 
 lo
ops—   in
fo flows.  This is one of the

lo
ops—   in
fo flows.  This is one of the 
main goals of commercial commodity markets, to provide more complete information and more accurate, effective feedback loops. If you were a farmer in Illinois in the 1800s and your county had a great corn crop, the price you received 
195612 i-x 1-214 r4pm.indd  10 6 2/ 19/14  2: 46:25 AM

1 0 7was probably down, even if three counties over there was a drought and 
 re
cord-   hi
gh prices. With effective commodities 
markets, a more accurate view of outputs and availability should help both buyers and sellers.
In its essential, 
 us
er-  or
iented form, a healthy commodi-
ties market matches the natural principles of attunement pretty well. Probably a B
-pl
us, or even an A -mi
nus.

-pl
nus.
As with all markets, though, expansion in commodities 
has brought challenges. For entities that actually use alumi-num or corn in their business, we can see how commodities markets provide helpful tools. But what about entities that do not use any aluminum in their business, yet participate in the same financial markets as those that do?
Here we hit a slippery slope, the slope between business

management, investing, and speculation. In the context of food commodities, speculation is especially important, due to the different functions and flexibilities of food versus, say, metals. If copper prices are very high, construction projects get delayed, inventories are depleted, new sources of supply and substitute materials are sought. Usually, eventually, those adjustments recalibrate prices, and any-thing that was delayed can be resumed. But if corn prices are very high, people go 
 hu

hu
ngry—   an
d it’s no comfort that 
prices might come down in a few weeks or a few months. The hunger is real, and it’s now. This intersection between natural systems, financial systems, and social systems is complex and vital, in ways that do not seem well reflected in our regulatory, operating, or analytical processes.
195612 i-x 1-214 r4pm.indd  10 7 2/ 19/14  2: 46:25 AM

1 0
8Here is a simplified summary of changes in commodi-
ties trading in recent years:
• De
rivatives activity in commodities markets rose 
steadily through the 1990s and became a source of concern for the Commodity Futures Trading Commission (CTFC).
8
• However, rather than increasing restrictions, in 2
000, the Commodity Futures Modernization 
Act was passed, which exempted certain markets (such as energy futures) from CFTC oversight.
•
 Th

•
 Th
e Gramm, Leach, Bliley Act was passed around 
the same time, which allowed all sorts of new finan-cial players to participate in commodity markets.
•
 Th
e Chicago Board of Trade (CBOT), the pri-
mary agricultural exchange in the United States, raised speculative limits on grain and oilseed contracts too.
•
 En
couragement for the idea of “commodities as

En
couragement for the idea of “commodities as 
an asset class” rose in both academic and finan-cial circles, which contributed to a rise in com-modity index funds from $13 billion in 2003 to $317 billion in 2008.
9 By 2008 it is estimated that 
these funds accounted for 41 percent of open long interest in commodities markets.
10
• Perhaps as important as the data above, the p
erceptions of many participants in food com-

modities markets seem to have shifted as well. Whereas many individuals involved in these markets historically had some sort of personal 
195612 i-x 1-214 r4pm.indd  10 8 2/ 19/14  2: 46:25 AM

1 0 9tie to agriculture, or at least direct knowledge of how their markets linked to the world, a senior exchange official was quoted in 2010 as saying, “I view what we’re working with as widgets.”
11 In 
my experience, this disconnected point of view is very common.
To be sure, most of the time, most of what’s happening 
with commodity prices can still be explained by underlying 
 su
pply–   de
mand dynamics. But what about when specula-

tion is a factor, what happens then? Examining food com-modities in particular provides a fascinating and troubling set of answers.
For food commodities, we generally have a 
 lo
ng-  te
rm 
backdrop of rising demand due to population growth and global wealth increases, plus some natural limits on ara-ble land and production levels. This combination of rising demand and somewhat limited supply would tend to make 
 lo
ng-  te

lo
ng-  te
rm prices rise. Supply and demand are just as relevant 
for food commodities as they are for any other market, and before 2000, supply/
 de
mand-   ba
sed economic models pro-
vided strong, fairly complete explanations of food prices.
However, in recent years the proportion of the change

in food prices that can be explained solely by supply and demand has been shrinking, indicating that there must be other factors at play. Specifically, as shown by researchers at the New England Complex Systems Institute (NECSI), since 2000, two additional elements have risen in impor-tance when it comes to explaining food commodity prices: ethanol, and deregulation.
12 Ethanol policy has increased 
195612 i-x 1-214 r4pm.indd  10 9 2/ 19/14  2: 46:25 AM

1 1
0demand for corn, which creates upward price pressure for both corn and related crops. And as noted above, deregula-tion had two types of influences: first, it has made it possible for more and more investors to participate in commodities markets, and second, it has made speculation easier.
Still, why should we care if speculation is causing price

spikes? It’s not like we go to the store to buy bushels of corn. Oh, wait, we do. As Michael Pollan has highlighted, more than 
 on
e-  qu
arter of items in our supermarkets 
contain corn, often in the form of corn syrup,  co
rn-  fe
d 
chicken and beef, and corn oil.13 There is a tangible and 
direct link from this speculative activity to our consumer experience.
Even more interesting than higher prices at the super-
market checkout 
 li
ne—  an
d far more  co
ncerning—   is
 mount-

li
ne—  an
 mount-
ing evidence that commodity price swings contribute to social unrest. A recent study from the same team at NECSI explains the link between food commodities and public violence. As you’d expect, there are many underlying fac-tors that contribute to social unrest, such as poverty and social injustice. But this study found that high food prices, and especially high and volatile food prices, made violent outbreaks more likely.
14

14
This research highlights several important contributing 
layers to analyze. First, we have created enabling conditions for dysfunction in the structure of our underlying food sys-tem: many countries are more reliant on the global markets now, whereas historically local supply and subsistence farm-ing provided buffers to global volatility. Second, we have 
 me
dium-   te
rm, structural price pressures on corn due to 
195612 i-x 1-214 r4pm.indd  11 0 2/ 19/14  2: 46:25 AM

1 1 1government policy, particularly ethanol requirements. And finally, we have introduced significant speculative activity, which has extended price spikes beyond what a nonspecula-tive, supply and 
 de
mand–   dr
iven market would produce.
This combination of factors, and especially the spike in

speculation, is clearly tied to social unrest. In other words, the actions of corn speculators in Chicago are directly linked to food riots in Egypt, Libya, and Syria. These riots caused deaths of thousands of people in 2011.
15 One could

15 One could 
argue, as noted earlier, that speculation in something like penny stocks is “just a game,” where the impacts, though direct, are fairly limited in scope. But speculation in food commodities markets casts a long shadow. It causes hunger, suffering, and violence. As John Fullerton, founder of the Capital Institute notes, “Commodity market manipulation is fundamentally different and far more dangerous than the 
 ga
rden-   va
riety manipulation of financial markets such as

riety manipulation of financial markets such as 
in single stock pump and dump schemes, or even the bra-zen manipulation of LIBOR. Nobody eats LIBOR.”
16
An examination of current food commodity markets, 
influenced by legislation, regulation, and speculation, reveals a system much less in alignment with the “life in context” principles:
• Does it use readily available materials and energy?

There is a sort of “false energy” being pulled into commod-ity markets due to the expansion of external factors like ethanol legislation and financial speculation. These influ-ences are less and less connected with the core function of commodities and the original function of their markets.
195612 i-x 1-214 r4pm.indd  11 1 2/ 19/14  2: 46:25 AM

1 1
2• Does it cultivate cooperative relationships? The fun-
damental cooperative nature of markets has been distorted here by a three
-in-on
e combined commodities market func-
tion: we have the core commercial market, the legislatively induced market, and the speculative market. Each set of participants has different needs and motivations, which are disconnected and out of sync with one another. This is fun-damentally a fragile and volatile system.

• Does it leverage cyclic processes? Relationship of 
commodity markets to the natural cycles of crop growing is more and more distant, due to the expanded market par-ticipants and purposes.
• Does it use effective feedback loops?  Feedback loops 
are distorted by these same market extensions, rendering correction mechanisms less effective as well.
Not only does speculation amplify price swings, and

not only do those price swings increase the fragility of our social systems, but that fragility is causing tangible human harm and suffering. We see in the food commodity mar-kets a combination of market disruption and moral disrup‑
tion. This is a dangerous combination, one that demands 
understanding and correction.
Evolution

Evolution
It would be easy to overlook one of the most vital elements of the analysis we’ve referenced in this chapter: the idea that local food systems used to be more robust, and that 
195612 i-x 1-214 r4pm.indd  11 2 2/ 19/14  2: 46:25 AM

1 1 3many parts of the world used to be less reliant on global food commodities than they are today. The effects of the legislation, deregulation, and speculation discussed above would not be so awful if they did not directly impact so many dispersed local systems. So, yes, we likely need to make some major adjustments to commodities markets. But we also need to strengthen the local systems that can buffer impact. It’s like building up coastal ecosystems so that there is more shelter from ocean

Luckily, there is a lot of vibrant local investing activ-
ity, and much of it is particularly focused on nurturing and strengthening local food systems. For example, the Slow Money movement focuses on “bringing money back to earth” and “investing as if food, farms, and fertility mat-tered.”
17 Numerous local chapters have emerged to provide 
on- th
e-  gr
ound focus in their own regions through investing,

education, and support for local entrepreneurs. I belong to a lending group in Boston that is affiliated with our local Slow Money organization and it has proven to be a great way to better understand and invest in our local food sys-tem, to meet real live farmers and entrepreneurs who help to 
 no
urish that system, and perhaps most importantly, to 
work with other local friends toward shared benefit for our community.
The Business Alliance for Local Living Economies

The Business Alliance for Local Living Economies 
(BALLE) focuses on creating prosperity through vibrant local economies and communities, with eighty local busi-ness networks and a broad offering of opportunities for education, connection, and investment.
18 I admire that the 
BALLE localism movement focuses on the entire system, 
195612 i-x 1-214 r4pm.indd  11 3 2/ 19/14  2: 46:25 AM

1 1
4recognizing that energy, food, business, and community are all inextricably linked, and that to focus on a single ele-ment in isolation will not enable 
 fu
ll-  sy
stem prosperity.
Finally, community development financial institutions 
(CDFIs), over one  th
ousand-   st
rong in the United States,

ousand-   st
rong in the United States, 
continue to provide crucial small business funding in many communities. As a group, CDFIs grew lending and credit union assets faster than traditional counterparts straight through the 
 la
te-  20
00s’ financial downturn.19
These three are just a few examples of a broader wave

of local engagement that can be witnessed in political, social, and economic contexts across the globe. And many of these endeavors are supported by the simpler, more direct mechanisms that form the basis of transformation from synthetic to simplified. We can start to see how these transformations intertwine and reinforce each other, form-ing the basis of a healthier investing ecosystem.

How can we move toward investing that is more connected, more in context? Nature’s principles of local attunement offer a path.
In natural terms, local often means nearby. But even 
more than that, it means connected. First think of the literal meaning of local. Is some of your investing centered in your own community? Are there ways to connect your resources more with your local life? Then think of the more meta-phorical “local,” that is, connected. When you look at your

1 1 5account statements, do you know what’s in those funds? Do you know the products that the companies produce? Can you explain the details of each security? You don’t need to know every detail of every investment (though that is a noble goal), but if you don’t even recognize most of the list-ings on your own account statements, it might be time to sift through to see which are really serving valuable pur-poses and which are more speculative, or just “fillers.”

When I think of the house building work I’ve done with 
Habitat for Humanity, I am struck by the many layers of connection that are present: connection to place, connection to community, connection to mission, and connection of people across all sorts of possible 
 di
visions—   re
ligious, politi-

di
cal, and national. Unfortunately, I still don’t see this kind of connection present in all of my own investing, but I am more and more focused on identifying it and pursuing it. If I can’t describe how my investment is visible in the world, that’s one strike. If I can’t explain its direct and indirect effects (hopefully benefits) in some detail, that’s two strikes. If I can’t even explain how it works, that’s three 
 st
rikes—  
 ou

st
rikes—  
 ou
t. By filtering my investing through these questions, I am 
trying to move my investing bit by bit from transactional to 
relational.
Sowing Seeds of Locally Attuned Investing 
Here are some ways to move from transactional to rela-tional investing, to focus on investing that thrives in context:
195612 i-x 1-214 r4pm.indd  11 5 2/ 19/14  2: 46:25 AM

1 1
6• Define context. Decide what constitutes the context 
of your investing. Maybe you want to focus on a certain set of themes or a type of organization, a geographic region, or a type of security. Define what is “local” to you.
• Cultivate cooperation. Try to back off the alpha

tendencies for just a moment, and recognize that we are surrounded and supported by cooperative systems. Compe-tition can be helpful, but it floats in a massive sea of coop-eration, and it need not be a zero sum game. Are there ways to achieve your purpose that do not involve crushing some-one else? There probably are. Better yet, could you achieve your purpose by supporting someone else? I bet you could.
• Create dynamic/
 re
sponsive—   he
althy feedback loops.

re
althy feedback loops. 
What information are you monitoring for your investments? Feedback loops need to include relevant information, effec-tive processing, and appropriate response. What kinds of feedback will let you know what’s really happening, and if adjustments are needed? Daily price reports and constant investment turnover are not likely to be the most useful inputs.
As we attune to our own contexts, our local environ-

ments, our investing naturally becomes more connected.
We can eliminate harmful, needless speculation, and 
focus on investments that are valued and valuable to both parties.
We can recognize the ubiquitous cooperative systems 
that enable our small moments of competition.
We can move from disconnected to reconnected.
195612 i-x 1-214 r4pm.indd  11 6 2/ 19/14  2: 46:25 AM

1 1 7Transformation 5
From Mechanical to Mindful
You’re right on the line!” an agitated audience member 
proclaimed. I had just presented results for the  mi
d-  ca
p 
funds I was managing to a big group of financial advisors.
“Ummm, what line?” I asked, a little bit confused. The

backdrop to these meetings was a positive one: the funds were doing well, and so was the overall stock market (this was the late 1990s), so it was unusual to meet an unhappy investor. My first alarming thought was that he meant some sort of ethical line, or a personal 
 on
e—  th
at he did 
not approve of some of the fund’s holdings, or thought I had invested too much in technology stocks.
“This one!” he poked his finger at a set of papers. It 
was not a metaphorical limit he 
 me
ant—   it

 me
ant—   it 
was an actual 
line, the line in the Morningstar chart that placed my fund in the 
 mi
d-  ca
p growth box. Sure enough, my fund was 
right on the edge between “blend” and “growth.”
“I have to sell your fund if you cross the line,” he 
explained, eyes wide. “Don’t cross the line.” It turned out that his firm had a strict asset allocation policy, so that if “
195612 i-x 1-214 r4pm.indd  11 7 2/ 19/14  2: 46:25 AM

1 1
8my fund moved from one box to another, he would indeed have to sell it.
“Well, I’m just buying the best 
 mi
d-  ca
p stocks I find,” 
I replied, trying to emphasize that my responsibility was to shareholders and not to the chart he held. He turned away in frustration, shaking his head.
This was my first clue that our assessment tools had

taken on a life of their own. They had begun to influence our practices and cause us to adapt, but not in a healthy or intended way.
Nature’s Principle: Adapt to Changing Conditions
Adaptation is a curious concept for investors: we want to be nimble and to be able to adjust as the environment shifts, but we also want to be consistent and reliable. The detail behind the natural principle adapt to changing conditions

acknowledges that we live in a world that is constantly in flux and illustrates that adaptation is not just about any old response. It’s the appropriateness of response that mat-ters, the way that the response is triggered and managed. Proper adaptation requires designs and processes that are inherently dynamic, not static. The subprinciples of adap-tation are:
•
 Ma
intain integrity through  se
lf-  re
newal.
• Em
body resilience through variation, redun-
dancy, and decentralization.
• In

• In
corporate diversity.
195612 i-x 1-214 r4pm.indd  11 8 2/ 19/14  2: 46:25 AM

fr o m  meCh aN I Ca l  t o  m I Nd f u l
1 1 9The first element of adaptability is the ability to main‑
tain integrity through  se
lf‑  re
newal . What does this mean? 
Persistence! Perseverance! Adaptable organisms are con-stantly adding energy and resources to heal and improve the system, on both micro and macro levels. Think of a tree that loses a big branch in a 
 sn
owstorm—   if 
it’s healthy,

sn
it’s healthy, 
by the next spring you’ll usually start to see new branches forming near the lost limb. Or consider our own bodies, healing cuts by marshaling all sorts of different resources to clot the blood, fight infection, and form new skin and scar tissue around the wound. 
 Se
lf-  re
newal is the process of 
maintaining integrity, not of holding a rigid form constant in the face of change.
Adaptation also requires embodied resilience . It’s not

enough to be resilient only in theory: this quality must be actively demonstrated and fostered through variation, 
redundancy, and decentralization . The quirky little sea slug 
called a nudibranch shows how these qualities are positive and necessary. Obviously, a slug is a vulnerable 
 cre
ature—  
 sl
ow moving and unprotected, offering a squishy, easy meal

for predators. To protect themselves, nudibranchs are often crazily, garishly colored, alerting predators to toxicity. In a stunning show of adaptation, the source of this toxicity is directly related to the nudibranch’s particular environment: for example, many varieties protect themselves by eating toxic substances like the stinging cells from jellyfish ten-tacles or anemones. Instead of being poisoned themselves, the nudibranchs pass the toxins through to harm would
-be 
p

-be 
p
redators. Other sorts of nudibranchs, rather than sport-
ing loud colors of warning, take on the color of their own 
195612 i-x 1-214 r4pm.indd  11 9 2/ 19/14  2: 46:25 AM

1 2
0food  sources—   so , for example, one feeding on coral will be 
coral colored, invisible to attackers. These adaptations to local food sources allow the nudibranch to thrive in shift-ing (and threatening) conditions.
1
A glance at sea slug photos (really, take a look!) reveals

stunning variation within the species, while the multiple mechanisms for “borrowing” toxins from other creatures demonstrate redundancy. The way that adjustments are localized to each particular environmental setting reflects decentralization. Those three 
 ch
aracteristics—   va
riation, 
redundancy, and  de
centralization—   te
nd to have a negative

nd to have a negative 
tone in business settings, where we often aim for consist-ency, efficiency, and centralization. But resilience is every investor’s dream: to be able to prosper in a range of chang-ing environments, with all sorts of resource shifts and a wide mix of neighbors, some with friendly intentions and some more predatory.
The final component of adaptability, diversity , might

at first seem to be the same as variation, discussed above. However, while variation refers to the mix of organisms, diversity refers to the mix of forms, processes, or systems that exist to perform a particular function. Variation is a mixture of “what,” but in this context, diversity is a mixture of “how.” In a forest, we can easily see the distinction: trees can regenerate through internal growth, seedling growth, or new shoots from old roots. Water capture can come from root systems,

roots. Water capture can come from root systems, geographic features, or built structures. There are many different trees (variation), and also many ways for regeneration and water capture to occur (diversity).

Three key themes are embedded within the natural 
195612 i-x 1-214 r4pm.indd  12 0 2/ 19/14  2: 46:25 AM

1 2 1principles of adaptation. First, the concept of  se lf‑  re newal 
as a dynamic cycle. Perhaps I am  ov
er-  co
nditioned by years 
of exposure to women’s magazines, but when I see “  se
lf- 
 re
newal,” I tend to think of “antiaging” or turning back 
the clock. That association is completely misplaced in the context of biomimicry. Here, 
 se
lf-  re
newal does not imply

se
lf-  re
newal does not imply 
going back to some prior form; rather it’s a tool for healing, change, and improvement. Going forward.
Luckily, outside the realm of beauty creams, this sort 
of 
 se
lf-  re
newal is a familiar idea. For example, education 
and training are forms of  se
lf-  re
newal, adding energy and

lf-  re
newal, adding energy and 
resources to acquire new knowledge and capabilities. One of the most common aspirations in the business community is to be part of a “learning organization.” Similarly, Charlie Munger, Warren Buffett’s longtime business partner, often discusses his efforts to build diverse “mental models,” so that he has intellectual frameworks that help to navigate a wide range of situations. Early in his career, Munger real-ized that this 
 se
lf-  re

se
lf-  re
newal was so important that he decided 
to bill an hour a day to himself, so that he could invest the time in projects that interested him, rather than projects other people paid him to do.
2 Whether physical, emotional, 
spiritual, or intellectual, these types of personal invest-ments in renewal are all ways to build adaptive capacity.
Resilience is also a commonly confused term: the

Resilience is also a commonly confused term: the 
perception is that resilience means “bouncing back,” but the concept is more nuanced than that. In biological terms, resilience is about maintaining function in light of 
 di
sturbance—   no
t retaining form, not recovering to an orig-
inal state. Within nature’s principles, resilience is explicitly 
195612 i-x 1-214 r4pm.indd  12 1 2/ 19/14  2: 46:25 AM

1 2
2multidimensional , incorporating variation, redundancy, 
and decentralization.
Those resilient qualities might sound fine for a forest,

but in many human endeavors it’s not so clear that they’re desirable. In business, “redundancy” is usually a synonym for “waste.” Indeed, in human resources circles, when you are “made redundant,” it does not mean you’ve won a prize for your contributions to resilience; it means you’ve been fired. We tend to view the main mechanisms of 
 re
silience—  
 va
riation, redundancy,  de
centralization—   as 
enemies of

enemies of 
efficiency. In our quest for efficiency in human endeavors, we can decrease resilience.
The third embedded concept in the adaptation princi-
ples is that diversity is an asset. This might be well under-

stood in some organizational settings, but it is very rarely acknowledged in process design, where our assumption is that standardization is the best approach. There are a few specialties that value diversity, like airplane safety or nuclear engineering, where we want multiple options for landing the plane or shutting down a reactor core. But these are the exceptions, not the rule, and even then, we usually choose a mix of standardized options. Diversity of mechanisms is the exact opposite of

Diversity of mechanisms is the exact opposite of standardization, and it is standardization that’s been the hallmark of our business practices since the days of Henry Ford. Of course, stand-ardization might be well suited for assembly lines, with predictable work flows and homogeneous products, but we have misapplied it to many endeavors like investing, where conditions, products, and processes are constantly in flux.

1 2 3Translation to Investing
The qualities of natural adaptability are not always embraced in business, but they still seem like no
-br
ainers when it 
comes to investing. We all recognize the inherent risks and uncertainties presented by a changing economic and invest-ing environment, and the qualities of adaptability (and http://www.amazon.com/  Ho neybee-   De mocracy-   Th omas -D-Se eley/dp/0691147213;

http://www.nbb.cornell.edu/seeley.shtmlFigure  5–  1 Ad apt to Changing Conditions: The Swarm
When bees seek a new hive location, the same simple rules guide infor-mation gathering and decision making: every scout is seeking to opti-mize location characteristics such as sun, safety, and height.
195612 i-x 1-214 r4pm.indd  12 3 2/ 19/14  2: 46:25 AM

1 2
4especially of resilience) represent a clear way to develop capabilities for navigating that changing environment.
Indeed, the premise behind most modern portfolio

Indeed, the premise behind most modern portfolio 
theory is that investors want to manage and mitigate risk. Unfortunately, as the theory has been put into practice, we have increasingly used narrow quantitative measures of risk like beta and VaR (value at risk) as proxies for the broader, more qualitative concepts of risk and uncertainty. This 
 mi
smatch—   th
e narrowness of the calculations versus 
the breadth and depth of the concepts they  re
present—   ca
n

n 
have devastating consequences.3
Even in this one small corner of portfolio theory, we 
see two different problematic layers. First, the mechanical layer: the calculations themselves are very narrow, each focused on just one subset of risk. Second, the human layer: this data is often misapplied and misunderstood, used to leap to much larger associations and conclusions than is warranted.
Though intended to explain and to control risk, many of

our mechanisms for managing risk have only focused on very narrow, 
 sh
ort-  te
rm measures. These tools have not improved 
 lo
ng-  te
rm risk management, and have not increased adapt-

ability; instead, they have unwittingly decreased it, by estab-lishing more and more structured approaches that inherently have less variation, less diversity, less flexibility. We have chosen rigidity instead of responsiveness, in the hope that the walls of ever more solid structures and processes will repel risk and uncertainty at the perimeters of our endeavors. We have sought 
 co
ntrol—   an
 impossible  go
al—  in
stead of aiming

impossible  go
al—  in
stead of aiming 
for adaptability and resilience.
195612 i-x 1-214 r4pm.indd  12 4 2/ 19/14  2: 46:25 AM

1 2 5Natural Scorecard: Mutual Funds and Their Analytics
At first glance, mutual funds seem to be among the  sl ower-  
 mo
ving organisms within the investment world. The struc-
ture of these products has been pretty constant for the last 
 se
venty-   fiv
e years, and they rarely carry the same sizzle in 
the headlines as  hi
gh-  fr
equency trading or hedge funds do.

gh-  fr
equency trading or hedge funds do. 
But this underlying stability of form is exactly what makes mutual funds the perfect illustration of misdirected adap-tation in our investment practices. The funds themselves have changed much less quickly than their 
 ec
osystem—   th
e 
tools, policies, and procedures that surround them.
The steadiness in form also reflects a steadiness in func‑

tion for mutual funds: far and away, their main function in the investment ecosystem is to provide diversification for investors. After all, it is a mutual fund! The whole point of 
a mutual fund is that people are coming together to share in both risks and returns. In natural terms, a mutual fund allows investors to invest in a small piece of a whole forest, instead of owning just one tree or a colony of beetles or a few acorns.
The principles of adaptability were easy to observe in

fund management for more than fifty years. As recently as the early 1990s, the most common type of mutual fund was a “go
-an
ywhere” fund, where the portfolio manager had 
wide discretion over where to invest shareholders’ money. If 
 la
rge-  ca
p U.S. stocks looked attractive, they might be a 
fund’s largest holdings. If the manager believed there was more opportunity in small international companies, she 
195612 i-x 1-214 r4pm.indd  12 5 2/ 19/14  2: 46:25 AM

1 2
6could invest there instead, without extra permissions or external approvals or fear of “crossing the line.”
How does the basic mutual fund structure hold up to 
the standards of adaptation?
• Does it adapt to changing conditions? Is it appropri-
ately  reactive?  A fund can 
 se
lf-  re
new by redeploying assets 
from one holding to  an
other—   th
ough whether reactions are 
appropriate depends on the manager and the circumstances.

• Does it maintain integrity through  se
lf‑  re
newal? A 
fund can demonstrate resilience through variation, redun-dancy, and decentralization of its holdings. As one of my early mentors said, “The greatest thing about fund manage-ment is, when things change, you can change your mind.”
4
• Does it embody resilience? Does it value effectiveness 
over efficiency? Does it incorporate diversity?  Yes, a fund

can incorporate diversity by holding multiple types of securi-ties and multiple types of businesses.
The fundamental structure of mutual funds is pretty 
well aligned with natural principles of 
 ad
aptability—  
 so
mewhere around an A -mi
nus. But as the number of 
mutual funds grew, so did the need to distinguish one fund from another. One essential challenge was sheer 
 vo
lume—  
 va
riation, as defined in our principles above. An individual

investor might be expected to sort through a few dozen options to make a reasonable choice, but several thousand? With more than three thousand U.S. mutual funds by 1990 (up from 564 in 1980), there were practical and serious issues of navigation that needed to be addressed.
5
195612 i-x 1-214 r4pm.indd  12 6 2/ 19/14  2: 46:25 AM

1 2 7Another challenge at this time was variability: not only 
were there many funds in number (variation), but their results were also quite disparate (variability). Fund investors were being called upon to navigate a more and more complex landscape, but without many maps or tools to assist them.
With the proliferation in numbers of mutual funds and

dispersion of their results, the stage was set for the devel-opment of tools to sort through all of that data. One early example of a tool for fund analysis is the investment style box, pioneered and popularized by Morningstar. This sim-ple three
-by-th
ree grid sketches out categories for small-, 
mid-, and  la
rge-  ca
p funds on the vertical axis, with value, 
blend, and growth styles across the horizontal axis.
Here is a quick review of the evolution of this one 
investment tool:
• The sty

• The sty
le box tool  was developed in 1992 by Morn-
ingstar. Early on, the style boxes fulfilled their role exactly as designed: thousands of mutual funds on jumbled
-up
 lists were 
sorted into straightforward categories, based not on what their names implied but on the data of their actual holdings. This was a huge service: now it was easy to tell which “
 la
rge- 
 ca
p” funds were secretly full of $300 million retail stocks and 
which “value” funds were full of  hi

gh-  fly
ing biotech holdings.
• The too
l ha
d (a
nd ha
s) cl
ear and legitimate function . 
Morningstar’s own advice notes: “How lines are drawn among value, blend, and growth is somewhat arbitrary, and it is perfectly acceptable for a fund manager to invest in a range of styles. The Style Box tool provides a context for understanding the holdings, not a constraint.”
6
195612 i-x 1-214 r4pm.indd  12 7 2/ 19/14  2: 46:25 AM

1 2
8• However, mis placed feedback loops began to take 
hold, and the tool began to influence decision making in an unintended way, as noted in this chapter’s opening story. A study published in 2003 found that changes in Morn-ingstar assessments had independent abnormal effects on fund flows (that is, effects independent of other perform-ance variables) of 13 to 30 percent.
7
• These style bo xes ha ve be come su ch st andardized tools

that they are increasingly used as part of the default construct for asset management. This is one factor leading to the popu-larity of “target date” funds, a type of 
 au
to-  ad
justing port-
folio that shifts assets between categories according to the shareholder’s stage of life. This type of fund had just under $50 billion in assets at the end of 2002, and mushroomed to approach $800 billion in assets at the end of 2012.
8
Unintentionally, what started out as a needed and help-

ful tool began to influence decision making in inappropri-ate ways. In this regard, the Morningstar boxes are just one example of a much broader and deeper trend. When we assess a mutual fund model that is heavily 
 too
ls-  in
fluenced, 
we see much less adaptability:
ately reactive? The more narrow a fund’s mandate (whether intentional or unintentional), the fewer opportunities there are for it to adapt.

• Does it maintain integrity through 
 se
lf‑  re
newal? It is 
more and more difficult for a fund manager to change her mind. Most funds are now managed by a combination of 
195612 i-x 1-214 r4pm.indd  12 8 2/ 19/14  2: 46:25 AM

1 2 9committees and computers, which dampens the opportu-nity for individual creativity and responsiveness.
over efficiency? Does it incorporate diversity?  Again, a fund 
manager who is trying to stay “in the box” is by definition constrained.
During this 
 to
ol-  in
fluenced era, discussions of businesses

ol-  in
fluenced era, discussions of businesses 
and products and whether they made for good investments have given way to discussions of tracking error, active bets, and portfolio construction. But the latter conversations rarely link those risk measures back to actual investments in the funds, or link those investments in turn to what is happening in the real world. We are increasingly attempting to manage

risk by measuring it, and in proper context this might be a helpful endeavor. However, our measurements are less and less connected to tangible activity in the world, and thus we are less and less well equipped to take appropriate action. Our investment dollars are clearly reflecting a desire to manage and minimize risk and uncertainty, but they are also reflect-ing a desire to automate those processes, to avoid thinking about them. And with everyone using the same tools, resil-ience of the

everyone using the same tools, resil-ience of the overall system is undermined.

This maladaptation of our funds and tools highlights an 
important paradox: one of the greatest conditions for resil-ience (variation of organisms) can also be related to condi-tions that are unappealing to investors (variability in results). How can we reconcile the high degree of dispersion that a resilient system implies with our desire for consistency?
To help sort out this paradox, it’s important to 
195612 i-x 1-214 r4pm.indd  12 9 2/ 19/14  2: 46:25 AM

1 3
0distinguish between two distinct elements, risk and uncer‑
tainty. Most of our tools are intended to help us understand variation (the range of elements) and manage variability (the range of results). The first part, understanding variation, is pretty well addressed by popular analytical methods.
But 
 va
riability—   br
eadth of  re
sults—   is 
a lot tougher to

eadth of  re
sults—   is 
a lot tougher to 
understand, and even more difficult to manage. Variabil-ity has two components. The first is 
 ri
sk—  wh
ere the range 
of possibilities is known but the outcome is not clear. The second is 
 un
certainty —  wh
ere neither the range of possi-
bilities nor the outcome is known. This distinction between risk and uncertainty was documented by Frank Knight in the 1920s, and has been well illustrated more recently by Michael Mauboussin, amongst others.

9 Think of risk as a 
question of where results fall along a normal distribution. Think of uncertainty as a situation where results fall in a huge, 
 wi
de-  op
en space.
If you illustrate these two pictures with hand gestures 
you can actually feel how different the challenges are: risk is a complicated but tidy mathematical exercise, while uncertainty is the great unknown. Really, try it. Put this book down and make these forms in the air. Risk
 . . . 
 a n
ice,

. . . 
 a n
ice, 
steady curve. Uncertainty  . . . 
 a w
ild flailing and flapping 
around. See? This is not a geeky irrelevant  di
stinction—  
 th
ese are fundamentally different concepts.
Here is the tough part: we can model risk until the cows 
come home, but there are no good models for uncertainty; in fact, that is the definition of uncertainty, that it is not 
 mod
el-  ab
le. And  th
at—  le
t’s admit  it
—  is 
terrifying. So as 
we’ve employed our  ev
er-  la
rger  ri
sk-  ma

er-  la
rger  ri
sk-  ma
nagement tool kits, 
195612 i-x 1-214 r4pm.indd  13 0 2/ 19/14  2: 46:25 AM

1 3 1it’s been easy to pretend that they work for uncertainty too. But they don’t.
Even worse, when we use ever more stringent mecha-
nisms to control risk, we undermine exactly the character-istics that are needed to withstand uncertainty. When we limit creativity on the part of fund managers, our intention is to reduce risk, but instead we limit adaptation. When we create funds of funds like those 
 ta
rget-  da
te offerings, our

ta
rget-  da
te offerings, our 
intention is to reduce risk, but in doing so, we limit diversity. When we increase regulation and distribution, our intention is to reduce risk, but instead we increase centralization.
Our efforts to control risk have been in direct conflict 
with building an adaptive, resilient system.
Evolution

When I survey the investing landscape, I’m encouraged to see more and more “unboxed” investment approaches springing up. Some of these are occurring in the social investing, impact investing, and patient capital arenas, where the lines between philanthropy and investing are more and more blurred. Organizations like Acumen are pioneering “first loss” investments with philanthropic dol-lars, which allow more traditional investors to collaborate more easily on innovative social business ventures.

easily on innovative social business ventures. Numer-ous family foundations have decided to deploy all of their

assets toward their missions, not just the 5 percent they’d normally give away in grants each year. Discussions of “
 fu
ll-  sp
ectrum” investing have flipped their focus, from 
195612 i-x 1-214 r4pm.indd  13 1 2/ 19/14  2: 46:25 AM

1 3
2centering on what vehicle to  us e—  th at is, what box to 
 ch
oose—   to 
what outcomes are  so
ught—   th
at is, what kind 
of world we want to foster with our efforts.
Some sense of the  en
ergy—   an
d  ch
aos—   su
rrounding 
these unboxed investment approaches can be gained by observing the SoCap conference, held every fall in San Francisco. Topics range from gender lens investing to 
 oc
ean-  re
lated endeavors to urban innovation to partner-

ships with indigenous communities.  . . . In 
short, everything 
that you likely won’t find on your 401(k) form. Yet. In one short hour at the conference this year, I ran into friends from my biomimicry class, a spiritual conscious investing group, a women’s research project, a local 
 food
–  ad
vocacy 
organization, and a good  ol
d-  fa
shioned venture capital

d-  fa
shioned venture capital 
firm. My mentor Susan Davis always advises that to start a revolution, you should throw a better party, and gatherings like SoCap are definitely more fun than most traditional Wall Street conferences are these days.
One critique of impact investing and other innovative

approaches is that they sometimes appear to be clubs that are closed to all but the very wealthy, due to curious laws that are intended to “protect” others from taking too much risk with their money. Thankfully, many people are not daunted by this set of structures, and are finding ways to invest “out of the box” with whatever mechanisms make sense. The Transition Movement is helping local communities invest in a 
 ca
rbon-   fr
ee future.10 Farmer’s markets and community

ee future.10 Farmer’s markets and community 
agriculture programs are seeing record growth throughout the United States. Gift giving increasingly includes 
 fr
ee-  tr
ade 
195612 i-x 1-214 r4pm.indd  13 2 2/ 19/14  2: 46:25 AM

1 3 3goods, charitable donations, or personal experiences, instead of 
 ma
ss-  pr
oduced stuff. None of these activities fits on the 
Morningstar grid, and that’s exactly the point.
Our search for resilience in portfolio management has been replaced by the 
 pa
rtial—   an
d often  fa
lse—   co
mfort of “risk

rtial—   an
d often  fa
lse—   co
mfort of “risk 
management.” Yet within that misdirected journey, we can still dig back to the roots, identifying helpful starting points to set us on a more adaptable course. And then we can send up shoots, beginning to take steps along a differ-ent, more resilient pathway of practice.
The first step on that more resilient pathway is to refo‑

cus the questions we are trying to answer and to expand them to their higher level of significance. We do not need to ask why the tracking error for any given mutual fund changed by 0.1 in the latest quarter; we need to ask whether we are building adaptable, resilient products and systems. This shift in focus is like tending the garden versus being constantly in harvest mode.
Most importantly, we need to consider how to prepare 
for uncertainty , and to acknowledge that this prepara-

tion might include things that appear 
 in
efficient—   or
 even 
 ri
sky—   in
 the short term. Preparing for uncertainty connects 
with all the principles of adaptation that we’ve discussed in this chapter: investing in renewal, variation, redundancy, decentralization, and diversity. This preparation is like 
195612 i-x 1-214 r4pm.indd  13 3 2/ 19/14  2: 46:25 AM

1 3
4planting fruit trees that will benefit your children more than yourself, or adding a few 
 dr
ought-   to
lerant species even if it’s 
raining this week and the risk seems remote.
Once we establish this initial reorientation toward

resilience in our investing, other layers of opportunity are revealed. For example, our portfolios should be adaptive and resilient, sure, but isn’t one way to accomplish this to invest in other entities that are themselves adaptive and 
resilient enterprises? This is the investing equivalent of planting new seeds, trying new crops. Some will fail, to be sure, but some will flourish.
With this question in mind, we can extend our thinking

beyond the current boxes and pie charts, which are mainly comprised of public securities of large institutions plus sometimes an extra wedge for gold or real estate. Once we consider adaptation and resilience seriously, the question is not whether 
 la
rge-  ca
p stocks will outperform small caps,

rge-  ca
p stocks will outperform small caps, 
or whether muni bonds will outperform Treasuries. The real question is whether our investing is supporting enti-ties that are themselves resilient, and that are contributing in turn to resilience of life on earth. This is not reflected in any asset allocation pie chart I’ve seen, nor is it answered by owning a fund of funds.
Many of the tools and processes that have been devel-

oped in investing over the last thirty years are rooted in modern portfolio theory. This theory reflects a clear desire to understand, measure, and control risk, but it has some major shortcomings, much like the mutual fund tools we’ve analyzed in this chapter. Most significantly, it narrows the definitions of risk. This makes it easy to misinterpret 
195612 i-x 1-214 r4pm.indd  13 4 2/ 19/14  2: 46:25 AM

1 3 5various calculations, and to assume they mean much more than they really do.
Employing life’s principles helps us to refocus on big-
ger, more essential questions, and bigger, more essential functions. This in turn enables us to redirect our processes, procedures, and 
 pr
oducts—   to 
realign them with essential

pr
oducts—   to 
realign them with essential 
concepts like adaptability and resilience. So instead of ask-ing, what Morningstar box does this fund belong in? Or, what is the Sharpe ratio for this portfolio? We can ask, is this approach adaptable? Does it demonstrate variation, redundancy, and decentralization? Is it reflecting diversity in how form meets function?
Sowing Seeds of Resilience in Your Own Investing

One of the most important words related to the adapt-ability principles is “appropriate”: the goal is appropriate 
reaction to changing conditions. Now that we have exam-ined some of the challenges our current investing has with respect to this principle, what is the appropriate reaction?
• Consider the distinction between risk and uncer‑

tainty carefully. Be sure to avoid relying on traditional risk tools in situations where the real concern is uncertainty.
• Use data as information, not as a prescription for 
action. Tools are just 
 th
at—  in
puts into the  de
cision-   ma
king 
process, not determinants of its outcome.
• Plan feedback loops that match the intended  fu
nction — 
 se
ek data that demonstrate alignment with adaptability 
195612 i-x 1-214 r4pm.indd  13 5 2/ 19/14  2: 46:25 AM

1 3
6principles. What’s measured should relate to the purpose of the investment, should refresh itself over time, and should be met with an appropriate receptor and reaction.
• Beware of “duration trading” —
  ap
proaches that might 
decrease  sh
ort-  te
rm risk are tempting, but they also might 
undermine  lo
ng-  te
rm resilience. Try not to trade one for 
the other.
• Invest in variation, redundancy, decentralization, and 
diversity .

Like farmers who are fostering resilience by replanting 
fields with multiple crops, natural windbreaks, and fewer chemical treatments, we can reinvest in adaptation and the roots of resilience: variation, redundancy, decentralization, and diversity.
We can move from rigid processes to responsive ones.We can shift from mechanical to mindful.
195612 i-x 1-214 r4pm.indd  13 6 2/ 19/14  2: 46:25 AM

1 3 7Transformation 6
From Static to Dynamic
It had been a tough morning. Our firm held a stake of 
several hundred million dollars in one of the stocks I was recommending, and the company’s quarterly results had fallen short of expectations. The stock was down more than 10 percent, so we’d lost tens of millions of dollars.
The 
 sh
ort-  te
rm disruptions at the company were well

explained, and most were of a transitory nature: a slipped deadline here, some cost inflation there. Of course, every analyst wonders what she could have done to better antic-ipate problems like these, but I had analyzed the results carefully and was confident that prospects for the busi-ness were still strong. I was recommending that we not just hold the stock but buy more, which is what I conveyed to the manager of the biggest fund at my firm, the one who held the largest position in this

He was not emotional or angry, despite the stock’s 
 de
cline—   qua
rterly results are always volatile, and we’d 
discussed this company together many times. Plus, every investor eventually learns how to calibrate his emotions, to try to distinguish between “noise” and more serious 
195612 i-x 1-214 r4pm.indd  13 7 2/ 19/14  2: 46:25 AM

1 3
8issues. At the end of our discussion he sighed a little and concluded, “Look, I understand the 
 sh
ort-  te
rm issues, and 
I’m not selling the stock. But be careful when you make claims about long term prospects after a quarter like this. The long term is a series of short terms.”
Is it true? Is the long term really a series of short terms? 
Life’s principles of evolution show that it is that
 . . . 
 an
d 
much more.

. . . 
 an
d 
much more.
Nature’s Principle: Evolve to Survive
Timing on Wall Street is a tricky thing. Though many investors intend to be 
 lo
ng-  te
rm in their orientation, 
we are constantly being pulled back to the day -to-da
y, 
minute -to-mi
nute measurement that is now part of invest-
ment culture. One colleague of mine who dared to divest his Internet stocks in 1998, long before the 
 do
t-  co
m bubble

do
t-  co
m bubble 
burst, was warned almost daily, “The market can stay irra-tional longer than you can remain solvent.”
1 And indeed, 
every day that stocks like Webvan and eToys rose was like an eternity for my friend, both in terms of performance for his funds and in terms of the psychic toll that it took to watch those prices soar and soar.
During this same period, another colleague positioned

his oversized market screens behind his desk, so he could work with his back to them for most of the day. I loved this idea and tried it eagerly, but I had to put the screens back in front within a few days because my back was so sore. I was spending all of my time twisting around in my chair, 
195612 i-x 1-214 r4pm.indd  13 8 2/ 19/14  2: 46:25 AM

fr o m  statI C t o  dyNa mI C
1 3
9mesmerized by the flashing red and green numbers. Much as I thought my decisions were long term, my 
 ac
tions—   at 
l
east in performance  mo
nitoring—   we
re decidedly micro 
term.
Stretching to embrace the truly  lo
ng-  te
rm view, as 
required by the natural principle, evolve to survive, can feel 
like an uphill battle for investors who are buffeted by  sh
ort- 
 te
rmism. Yet when I think of the best investors I know,

they have fully embraced this principle, always stretching to incorporate new ideas into their investment practice and always tacking toward the long term, even while immedi-ate issues demand attention too. The long term is a series of short terms, yes, but simply pasting together 
 sh
ort-  te
rm 
plans with no longer view will not produce a successful, resilient strategy.
The subprinciples of biomimicry’s principle of evolu-
tion are:
•
 Re
plicate what works.
• In
tegrate the unexpected.

• In
• Re
shuffle information.
What are the components of a durable, evolutionary 
approach? Three factors come together within this princi-ple to create a resilient strategy: first, replicate what works . 
This is a little like your grandparents’ motto, “If it ain’t broke, don’t fix it.” Think of a horseshoe 
 cra
b—  it 
looks

cra
b—  it 
looks 
like something that could have roamed around with the dinosaurs, in part because the crab has continued to repli-cate what works: the hard shell, the multiple eyes, the spiny 
195612 i-x 1-214 r4pm.indd  13 9 2/ 19/14  2: 46:25 AM

1 4
0“horn” for navigating. All of these features have existed (and persisted) for roughly 150 million years because they work.
2
The flip side of replicating what works is the incorpora-
tion of new elements: integrate the unexpected.  When the 
option for a new approach arises, it should be explored and, if successful, embodied in practice. An example here would be the snowshoe hare, which has giant back feet with claws that function like 
 sn

sn
owshoes—   pe
rfect for navigating across 
snowdrifted environments. When those feet first emerged, they were a mutation, one that happened to be especially well suited to the environment at hand. Another mutation allowed the hare to change color, so that it turns bright white in winter and 
 br
own-   gr
ay in spring, in order to blend

br
own-   gr
ay in spring, in order to blend 
in better with its surroundings. Over time the hares with these mutations fared better, and so the mutations gradually “stuck,” becoming integrated into the hare’s basic design. As habitats are now changing, some studies suggest that these mutations are a liability instead of a benefit, so it remains to be seen how the hares continue to attune in the short term, adapt in the medium term, and evolve in the long term.
3

3
The key connector between replicating what works 
and integrating the unexpected is the ability to reshuffle 
information. Biologically, most of this reshuffling happens via reproduction, where all sorts of 
 cros
s-  pol
linations and 
genetic variations are possible. The relationship between mammoths and elephants over time is a great illustration of information reshuffling; generations of the animal became less and less furry over time as their home climates became warmer and warmer.
4

1 4
1For human organizations and processes, these biologi-
cal principles reflect three important concepts. First is the question of embodiment : for evolution to work, new ideas 
are not just ideas, they are fully incorporated into processes and systems. For many years I lauded the idea of keeping an investment diary, where you set aside time to note impor-tant events, your analysis, your emotion, and your deci-sions. And yet for most of those years, that’s all I

di
d—  I 
li
ked the idea. It wasn’t until I actually started keeping such 
a document that I could see patterns in my own biases and my own analytical tendencies. It was not thinking about this record keeping that helped, or recognizing that it was a good idea; it was the embodiment of this practice that finally led to positive impact.
The second important concept embedded in these princi-
ples is the definition of success . Natural measures of success

are often easy to assess: if an organism survives, it’s successful. It’s tempting to translate this idea directly to our investment endeavors, to say that we have a “sink or swim” approach for new ideas or methodologies, but that’s a little too convenient, especially when our time frame for measurement is often very short. And in fact, to produce successful 
 lo
ng-  te
rm evolution, 
we need to accept gigantic failure rates  along the way. Most

mutations are short lived because they provide no benefit, and indeed sometimes they hinder survival instead of help-ing it. So we need to identify “graceful failure” mechanisms in our endeavors, a way to try new ideas without putting too much weight on their early, risky outcomes.
For example, Peter Lynch, legendary manager of the 
Fidelity Magellan Fund, often referred to his “farm team” 
195612 i-x 1-214 r4pm.indd  14 1 2/ 19/14  2: 46:25 AM

2of hundreds of tiny holdings. These holdings were so small that any one of them could not have much impact on the portfolio, good or bad, but having them in the mix allowed these new ideas to be monitored, compared with bigger holdings, and generally “tried out.” If they were successful, they could grow to have real positive impact on the portfo-lio, but if they were unsuccessful, the price of failure was not too high. Though Lynch didn’t describe it this way, this practice is a great example

it this way, this practice is a great example of applying evolutionary princi-ples to investing.

5
However, employing this kind of evolutionary practice 
in investing is relatively rare, as it is eclipsed by fear. Jer-emy Grantham, cofounder and chief investment strategist of Grantham Mayo van Otterloo, often notes that “The central truth of the investment business is that investment behavior is driven by career risk
 . . . 
 yo
u must never, ever be 
wrong on your own.”6 This very powerful, very human ele-
ment of investing puts personal survival ahead of principled 
 lo
ng-  te

lo
ng-  te
rm thinking. In some ways, this is the most evolu-
tionary approach of all: focus on survival. But focusing on 
 sh
ort-  te
rm survival as an investor often has the unfortu-
nate consequence of weakening the foundation for  lo
ng- 
 te
rm survival. Defining success over an appropriate time 
frame, then, is a difficult and necessary piece of the puzzle.
Finally, the principles of “evolve to survive” weigh in 
very strongly on the notion of open versus closed systems .

For many investment organizations, the allure of proprietary approaches looms large. Who wouldn’t want a proprietary trading system or a big stack of proprietary research to draw upon? But “evolve to survive” implies that we need to consider 
195612 i-x 1-214 r4pm.indd  14 2 2/ 19/14  2: 46:25 AM

1 4
3our esteem for exclusivity more carefully. For effective evolu-tion, we need to ensure constant pollination of new ideas, and a system that is too closed off and buttoned up simply cannot provide enough of this newness. Even if a closed group can bring in lots of outside data and ideas, if there is no 
 tw
o-  wa
y

tw
o-  wa
y 
flow, all it can offer in return is payment; there is no deeper exchange. For durable success, we need true exchange, not just paid data transfer. Though it is an uncomfortable shift, many investment organizations need to move from a propri-etary, internally focused 
 min
d-  se
t to a more open, innovative 
 min
d-  se
t: from preservation to renewal.
http://www.guardian.co.uk/environment/2011/apr/04/  ho neybees-   en tomb-   hive sFigure 6–1  Ev olve to Survive: The Pollinators

The nectar in flowers evolved from ferns, and its sole purpose is to attract pollinators. Likewise, bees evolved to be optimal 
 co
llectors—   a 
90
mg bee can hold 40mg of nectar.
195612 i-x 1-214 r4pm.indd  14 3 2/ 19/14  2: 46:25 AM

1 4
4Translation to Investing
As noted above, it can be hard to consider finance and investing in a truly 
 lo
ng-  te
rm, evolutionary context: some-
times even thinking beyond the next quarter feels like a curious, 
 ol
d-  fa
shioned sort of thing to do. And yet timing

shioned sort of thing to do. And yet timing 
is just as finely calibrated in nature: think of the mouse caught by a snake in just a fraction of a second or an apple tree that blooms just a few days too late for optimal pol-lination. Nature balances the short term and the long term just as successful investors do.
What is most essential in nature, as well as in invest-

ing, is adaptation and adjustment, across all time frames and all sorts of different environments. In fact, three of our six natural principles allude to adjusting, each with its own cadence. “Be locally attuned” is an immediate idea, focused on fitting in to the current environment at any given point in time. “Adapt to changing conditions” lengthens the time horizon to the medium term, explaining how best to thrive as the environment around us shifts. And “evolve to sur-vive” is the longest

shifts. And “evolve to sur-vive” is the longest duration of the three, concentrating on multigenerational change and survival.

Each of these principles references strategies for coping 
with changing circumstances, and each provides important road maps for investors as well. When it comes to evolution, the essential questions posed to investors are profound: What constitutes success? How can we manage the many small failures that are required in order to discover the factors that will lead to 
 lo
ng-  te
rm survival? How can we incorporate new 
195612 i-x 1-214 r4pm.indd  14 4 2/ 19/14  2: 46:25 AM

1 4
5information not just on the surface but deep in the “DNA” of our processes? How can we create systems that are robust and unique yet still open enough to allow for true exchange?
Natural Scorecard: U.S. Dollar Evolution
Exchange is at the heart of  lo ng-  te rm evolution, and there

are many forms of exchange that are employed in investing: there are stock exchanges, of course, but also exchanges of information, exchanges of wealth, and more human exchanges as 
 we
ll—  th
ose of connection and collaboration. 
One form of exchange, the use of modern currency, is so ubiquitous that we rarely stop to consider it in depth.
There are fascinating and important debates to be had

regarding the U.S. dollar: some argue for the return of the gold standard or some other measure of value that is linked to tangible assets. Others are intensely focused on mon-etary policy or on links between the dollar, deficits, and debt. These are essential questions, to be sure, but for the purposes of this analysis, we want to narrow our examina-tion to a simple and specific consideration of the dollar in one of its primary roles: as a means of exchange.

Think of this one main function of the dollar, means of 
exchange, and how it has evolved over time. A condensed view of the history of exchange includes a progression that looks something like this:
•
  Ba
rter—   di
rect exchange of services. “I’ll milk 
your cow if you feed my pig.”
195612 i-x 1-214 r4pm.indd  14 5 2/ 19/14  2: 46:25 AM

1 4
6•  Barter—   di rect exchange of goods. “I’ll trade you 
two pigs for your cow.”
• Co
mmodities as currency. “I’ll give you a peck of 
salt for your cow, and then you can trade the peck of salt with that other guy for two pigs.”
•
 Co
ins as currency. “Thank goodness we don’t 
have to drag around kegs of salt anymore! Here’s a sack of gold coins as payment for your cow instead.”
•
 Pa
per currency. “Even better! Here’s a promise of

per currency. “Even better! Here’s a promise of 
value in exchange for your cow.”
As this evolution took place, several clear advantages

emerged: for one thing, more and more people were able to connect with one another. By the time we were using commodities as currency, the cow owner did not need to know the pig owner in order for them to trade. And just as importantly, we could carry around salt (or coins or paper) instead of pulling a cart full of pigs behind us as a means of exchange. So we could trade over longer distances and longer time frames, as well as between more and more people.

This evolution of scope also involved a transfer of trust. 
Instead of having direct trust in the quality of the pig or the honesty of the owner, with currency as the means of exchange we could agree on a value, trusting in that cur-rency instead of the people or products at hand. Curiously, as money infiltrated many parts of the economy that previ-ously relied on direct ties, this circulation of trust was not 
 on
e-  wa
y. People began to evolve their use of money, link-

ing money to specific sorts of trusted social relationships by 
195612 i-x 1-214 r4pm.indd  14 6 2/ 19/14  2: 46:25 AM

1 4
7using it for indirect transactions like housekeeping allow-ances, pin money, gift certificates, tips, and food stamps.
7
More recently, we have moved from using paper to 
electrons as our currency. It might seem like forever since you had to physically go to a bank to withdraw money, but this electronic evolution has really occurred just in the last thirty 
 ye
ars—   th
e blink of an eye in evolutionary terms. As

e blink of an eye in evolutionary terms. As 
these electronic forms of finance have accelerated, trust in financial institutions has eroded: finance is the least trusted industry globally, according to the Edelman Trust Barom-eter.
8 There are many plausible and obvious reasons for this

erosion of trust in finance, of course, but part of the decline might have been enabled by our high trust in the dollar. When our trust in currency is high, perhaps our trust in institutions is somehow less essential.
Curiously, the latest evolution in currency, Bitcoin, 
includes a declaration of “
 no
n-  tr
ust” in its origin paper,

no
n-  tr
ust” in its origin paper, 
declaring: “What is needed is an electronic payment sys-tem based on cryptographic proof instead of trust, allowing any two parties to transact with one another without the need for a trusted third party.”
9 This evolution of trust with 
respect to currencies is a vital piece of the puzzle: Do we need currency that eliminates trust, or do we need currency where our trust is more justified than it might be today? 
Trust is usually considered a 
 hu
man-   ce

 hu
man-   ce
ntric quality, but 
its equivalent exists throughout natural systems. Most of what we would consider trust in nature is a result of effec-tive function and proven mutualisms, and that includes the 
evolution of function over the longer term. When we take the longer view, a wider range of questions appears and a 
195612 i-x 1-214 r4pm.indd  14 7 2/ 19/14  2: 46:25 AM

1 4
8wider range of assumptions is revealed. We think of the dollar as if it’s a static, permanent force, when in fact it has only existed in its current form for a couple of decades.
Given the rapid evolution of the dollar’s functions, it’s

no wonder that lots of public attention is focused on those expanded functions and whether they are appropriate. Cer-tainly, it is vital to question how and why we are using this particular economic organism in the ways that we are. But it’s just as vital to place all of those questions into a much 
 lo
nger-   te
rm evolutionary context. For now, let’s think 
about the central functions of the dollar, as a direct means 
of exchange and store of value, and how those functions

hold up against the principles of effective evolution:
• Does it replicate what works? Yes, the dollar builds 
upon the features of earlier exchange mechanisms and con-tinues to perform their essential functions.
• Does it integrate the unexpected? Pretty 
 we
ll—  th
e 
dollar has taken on different and evolving roles, and has served as a means of exchange in different environments over time.
• Does it reshuffle information?  The dollar has taken in

lots of inputs over time, from changes in policy to changes in other surrounding currencies. This is not quite a direct paral-lel to biological pollination and reproduction, but the dollar has interfaced with lots of other currency organisms over time and has evolved to maintain its overall function throughout.
On this basis, the dollar looks pretty sound (no pun 
intended)—a solid B grade. However, it’s not just a means 
195612 i-x 1-214 r4pm.indd  14 8 2/ 19/14  2: 46:25 AM

1 4
9of exchange anymore. How has the U.S. dollar evolved over the past century?
A quick survey of recent decades shows that we have 
evolved our use of the dollar to include all sorts of func-tions beyond being a (fairly) local means of exchange. Early on, function was extended to include acting as 
 cros
s-  bor
der

cros
s-  bor
der 
means of exchange and, more recently, as global means of exchange. Even more recently, the U.S. dollar has become a monetary policy tool, an international reserve currency, and a means of managing political as well as economic international relations.
Here is a brief summary of the extended functions of 
the U.S. dollar in recent decades:
• The
 do
llar st
ill se
rves it
s ea
rlier fu
nction as a me
ans 
of exchange, on a more and more extended basis.
• It al
so is us

• It al
so is us
ed as a me
ans of intervention , bought and 
sold by central banks and used as a tool in monetary pol-icy; it was used in programs like the Marshall Plan and the Dodge Line to finance U.S. exports for rebuilding overseas after World War II.
• The
 do
llar ha
s in
creasingly be
en th
e de
fault cu
rrency 
fo
r global contracts, used as a means of invoicing , even for 
trade that has no other link to the United States.
• And it is us
ed to de
termine ex
change ra
tes fo
r ot
her

ed to de
termine ex
change ra
tes fo
r ot
her 
na
tional currencies as well as many alternative currencies, 
making it a means of pegging value for these others.
• In ad
dition to it
s ro
le as a st
ore of va
lue,  do
llar- 
 de
nominated assets are held by private agents, where the dol-
lar is serving as a means of  banking and holding reserves.10
195612 i-x 1-214 r4pm.indd  14 9 2/ 19/14  2: 46:25 AM

1 5
0Of crucial importance, as these extended functions 
were evolving for the dollar, its connection to other stores of value ended when the gold standard was eliminated in 1971. Since that time the dollar has performed broader and broader functions with a greater and greater reliance on trust. There is no longer a precious metal underpinning our currency’s value, which may prove vital when trust wanes.
Given the 
 cros
s-  pu

Given the 
 cros
s-  pu
rposes noted above, let’s examine 
this multifunctional view of the dollar’s alignment with “evolve to survive”:
• Does it replicate what works? Well, we’ve contin-

ued to use the dollar as an effective means of exchange, and in fact this use has broadened. But we have taken up other mechanisms’ failures and put them all on the dollar, when we could have been evolving new and different tools instead. Ultimately, this overburdening may circle back to undermine the primary function of basic commerce as well.
• Does it integrate the unexpected? When any mecha-

nism is expected to fulfill disparate functions, it’s harder and harder to integrate the unexpected in one area without throwing others out of balance.
• Does it reshuffle information?  Since there is only one 
national currency in the United States (and increasingly con-centrated use globally), there is very little chance for 
 cr
oss- 
 po
llination, for the introduction of new features from the 
outside. This is a serious systemic risk.
Though natural systems do exhibit multifunctional

design, perhaps we have discovered the limits of multi  - 
195612 i-x 1-214 r4pm.indd  15 0 2/ 19/14  2: 46:25 AM

1 5
1functionality when it comes to our many uses for the U.S. dollar. The dollar as default currency may have made sense when the United States accounted for most of the indus-trial production in the global trading world. However, now the U.S. is only about 20 percent of trading output, yet the dollar is still our major global currency. This is a mismatch that seems unlikely to persist.
11 We have piled more and

11 We have piled more and 
more requirements on this one form of currency, quashing opportunities for other forms and mechanisms to take on some of the functional burden.
Evolution: Local Currencies and Other Forms of Exchange

Though the dollar may be overburdened with our extended expectations, there are plenty of examples of alternate forms of exchange in the world. Lots of attention has been heaped on Bitcoin, but we are already using many forms of alter-native, electronic currency without even thinking about it. That gift card from your grandma? Electronic currency. Air-line miles? Electronic currency. Your 
 fr
equent-   dr
inker card 
that you swipe at the coffee shop? Electronic currency.12

One of the most interesting alternative currencies, 
though, is not enabled by the Internet or fancy cryptogra-phy: the WIR is over 
 se
venty-   fiv
e years old. Launched in 
Zurich in the depths of the 1930s depression, the WIR is an organized bartering 
 sy
stem—   no
t for individuals, but for 
businesses.13 Value is pegged to the Swiss franc, but WIR 
francs are not convertible, so there is incentive for them 
195612 i-x 1-214 r4pm.indd  15 1 2/ 19/14  2: 46:25 AM

1 5
2to circulate within the system. The WIR system is a small portion of Switzerland’s economy, well under 1 percent of GDP, but it has been shown to provide disproportionate stabilization power, due to its countercyclicality.
14 In short, 
when other financial groups are retrenching, the WIR bank tends to be more active.
The motto of the WIR founders strikes a notably dif-

ferent chord than the Bitcoin manifesto: “Free exchange of goods and services, without exploitation of our fellowmen, and without government coercion.”
15 An independent, 
 tr
ust-  ba
sed system.
There are robust local currencies across the world, from 
Brazil to the Berkshires.16 And, increasingly, there are other

means of exchange for both goods and services, such as Freecycle and TaskRabbit. What is perhaps most encourag-ing is that newer technological platforms enable this sort of exchange on a scale that is both wide and deep. Businesses like Airbnb and Buzzcar allow the sharing economy to soar past the limits of physical proximity.
The rapid growth of these models has been enabled

by several critical factors, notes Robin Chase, founder of Zipcar and now Buzzcar. First, there is tremendous excess capacity of stuff in certain circles, and tremendous need in others. Cars are one of the most obvious examples of this excess capacity, but power tools, spare bedrooms, and even free time all have similar capacity dynamics. Second, there is a network of peer collaborators: individuals who are active participants in the system, not just passive consum-ers. And third, there are

not just passive consum-ers. And third, there are technology platforms to facilitate all of the matchmaking, validation, and technical expertise

1 5
3that are needed. Skype, Wikipedia, YouTube: all of these models rely on easy
-to-ac
cess platforms that enable excess 
 ca
pacity—   fr
om hardware to  id
eas—   to 
be more effectively 
deployed.17
These new means of exchange embody evolution, incor-

porating change as it occurs. They allow room to incorpo-rate small failures gracefully in order to improve the overall system. They are inherently open, transparent models, and trust is enabled through that transparency. In evolutionary terms, these developments are replicating what works while also integrating new features, functions, and capabilities.

Our reliance on just one form of currency to fulfill so many functions has resulted in an inherently fragile, overbur-dened situation. Unless you happen to be the chair of the Federal Reserve, or maybe secretary of the Treasury, it’s unlikely that major decisions about the fate of the U.S. dol-lar lie in your hands. Still, this example gives us some help-ful guidance on how to approach our own investing.
First, we can check to see whether our intentions are

embodied ones or whether they are just that, good inten-tions. Do your investments “walk the walk”? Whether you are aiming for steady dividend income, tangible commu-nity benefit, or responsible consumer choices, it’s helpful to test our actions versus our hopes, even if we can’t always fully assess the outcomes.
Second, we can clarify our vision of success, adding 
195612 i-x 1-214 r4pm.indd  15 3 2/ 19/14  2: 46:25 AM

1 5
4creativity that goes beyond simple dollars or percentages. In evolutionary terms, success is usually defined as sur-vival. What would success look like for your investing? A fancy new car? A college fund for your grandkids? A farm in your town that is saved from development? A 
 lo
nged-   fo
r

lo
nged-   fo
r 
trip taken or musical instrument mastered? How can we gently “mutate” and try new variations, recognizing that some won’t work out the way we hope? How can we help to perpetuate the ones that are successful?
Finally, we can be alert to whether the systems we 
engage with are open or closed. When I hear “open sys-tems,” I often still hear a voice in my head that translates to “unsafe” or “not secure.” I have the urge to lock some-thing. But an open system is just 
 th
at—  op

th
at—  op
en. It allows for 
iteration, for inputs from the outside, for healthy rejuve-nation and incorporation of new elements. I think of the 
 lo
ng-  te
rm history of the United States as one of the greatest 
illustrations of an open system: our country has thrived in large part due to constant immigration of new people, new ideas, and new endeavors.
Sowing Seeds of Evolution in Your Own Investing

As I translate this evolutionary approach to my own invest-ing, I ask myself, how might this investment change over time? Is it flexible enough to evolve on its own or will I have to be the one to do the adjusting? A 
 th
irty-  ye
ar T-bi
ll, 
for example, is a closed system; its design predetermines structure and duration. That’s great if it is a match for your 
195612 i-x 1-214 r4pm.indd  15 4 2/ 19/14  2: 46:25 AM

1 5
5needs, but investing with too much  ri gidity—   wh ether in 
form, function, or  ph
ilosophy—   le
aves us  fla
t-  foo
ted when 
times change.
How can we think about  lo
ng-  te
rm evolution for our 
investing?
• Be clear on what constitutes success for our invest-
ments.
• Be wary of overloading any one type of investing 
with too much function . Maybe all of our  gi
ving-   re
lated

ving-   re
lated 
investing should not be writing checks to charities, for example. We can invest time. We can invest in responsible 
 fo
r-  pr
ofit entities. We can invest in a more just world with 
our consumer dollars.
• Allow for multiple “currencies” —  di
fferent forms of 
investing, different reasons for investing, different organi-zations for investing. Different whats, whys, and hows.
• Invest with pollination in mind.  Pay attention to the

openness of your investing over time. Closed systems appear to be consistent because they’re rigid, but that is often false comfort when conditions change.
As we employ the principles of healthy evolution, we 
can ensure our own survival.
We can foster pollination and evolution through open 
systems.
We can shift from static to dynamic.
195612 i-x 1-214 r4pm.indd  15 5 2/ 19/14  2: 46:25 AM

Part III
Cultivation and Care
195612 i-x 1-214 r4pm.indd  15 7 2/ 19/14  2: 46:25 AM

1 5 9Biomimicry Investing: Resilient,  
Regenerative, Reconnected
It is easy to dodge our responsibilities, but we cannot 
dodge the consequences of dodging our responsibilities.1
—  Josiah Charles Stamp
This book has explored a number of detailed examples

from the financial world, presenting a long list of chal-lenges. When I step back from the detail, though, I see just three main fissures that run straight through to the bedrock of our systems. Repairing these three will bring us back toward the true nature of investing, toward a connected, beneficial financial ecosystem that is in service to our com-munities and our planet.
First, we have disconnected investing from the real world.

Automating analysis and trading, outsourcing expertise, and adding layers of synthesis and complication have improved efficiencies and created certain new opportunities. But most of these efficiencies are of the shallow sort, focused only on 
195612 i-x 1-214 r4pm.indd  15 9 2/ 19/14  2: 46:25 AM

1 6
0speed and immediate cost. And most of those opportunities have proven to be fleeting, looming large in the short term but fading quickly into losses over the longer term. Recon‑
necting , in all of its forms, is the first task of an engaged 
investor.
Second, we have narrowed our perspectives in a false

and needless way. We think of investing as only what shows on our brokerage statements, when in reality we are invest-ing with every action, every decision, every dollar. We con-sider profit and cost to be only what’s shown on financial statements, forgetting that we ourselves invented account-ing. Those numbers are tools, not truth. We examine data every day, every second, every microsecond, just because we can, pulling our attention away from the months and years to come, shrinking our field

the months and years to come, shrinking our field of vision to exclude the most important consequences and most complete views of investment returns. This shrunken focus traps us in a mind-set of extraction. Broadening our definitions to include longer term and more multidimensional measures of profit, cost, and investing is the first step to creating a regenerative

system, not just for finance but for our entire society and our entire planet.
Finally, we have chosen to create complicated, rigid

structures, instead of flexible, adaptive ones. Like the lit-tle pigs, afraid of the big bad wolf, we have built more and more defenses against the threats of our world, both real and imagined. But what happens when the threat of a big wind is replaced by a flood? We can never build complete defenses against uncertainty. And yet from investment allocation boxes to complicated regulations to entire firms 
195612 i-x 1-214 r4pm.indd  16 0 2/ 19/14  2: 46:25 AM

b Io mImI Cr y  I Nv e s tI Ng :  re sIlIeNt,  re g eNe r atIv e ,  reCoN NeCt e d 
1 6 1based on structured investment products, we have chosen the false security of 
 ev
er-  in
creasing structure, all the while 
increasing our ultimate fragility. Appreciating the need for adaptation, over all time frames, throughout all circum-stances, and at every level of scale is the beginning of creat-ing a more resilient system.
Fortunately, there is plenty of cause for optimism. I

must admit, as I dug into the investing examples of ventures gone awry, I was afraid that I’d find a core that was rotten, a system that was entirely lost to anyone seeking to reclaim the true nature of investing. I found just the opposite: time and time again, the kernel of true service, true need, true exchange, and true profit was alive and well. Admittedly, it was sometimes so small or covered up or removed from its original state that it was hard to identify, but still, it was there. At

was hard to identify, but still, it was there. At the core, if we peel off enough layers, there is still something solid to be built upon.

Also, we are surrounded by abundance. We have tools 
and capabilities for sharing knowledge and wisdom that have never existed before. We have the ability to connect not just in superficial ways but in deep and lasting ways across great spans of time and space and culture. We have growing 
 un
derstanding—   bot
h technically and emotion-
ally. We have not just tangible resources but also far more important gifts to draw upon: the wisdom of nature as mentor, model, measure, and muse.

Finally, we have ourselves! Throughout this book, I’ve 
emphasized that humans are a part of nature, and this is a delightful, vital truth. We also are pretty amazing and unique creatures. We have morals and ethics and the 
195612 i-x 1-214 r4pm.indd  16 1 2/ 19/14  2: 46:25 AM

1 6
2capacity for complex thought. We have tremendous capa-bilities that demand an equivalent level of responsibility and stewardship and engagement and care. We have com-passion and empathy along with information and skill. We have the ability to choose to cooperate for the greater good.
With all of these resources, we can engage in a rebirth 
of creative, independent investment thinking. We can take up our true and full 
 re
sponsibilities—   to

re
sponsibilities—   to 
ourselves, to each 
other, to our home. We can unbox our decision making. We can reweave our loose threads of investing back into the fabric of the world.
Using nature as the ultimate investing framework isn’t

romantic; it’s right. The narrowed, rigid approach we’ve taken served a purpose in its time, but it was a small pur-pose and a small window of time. This falsely linear view is an intellectually lazy one, unprofitable, and not even very interesting. With all of our resources, all of our gifts, we can do better. We have a responsibility to do better. And here is the greatest secret of all: embracing that messy mul-tidimensional complexity is so much more rewarding. It’s even more fun.

Here are the transformations needed, the steps on our 
path toward reclaiming the true nature of investing:
•
 Fr
om efficient to effective
• Fr
om synthetic to simplified
• Fr
om maximized to optimized
• Fr
om disconnected to reconnected
• Fr
om mechanical to mindful
• Fr
om static to dynamic
195612 i-x 1-214 r4pm.indd  16 2 2/ 19/14  2: 46:25 AM

1 6 3When we put them all together, we move our entire 
system:
• Fr
om fragile to resilient
• Fr
om extractive to regenerative
• Fr
This is a system that’s worthy of our full engagement, 
our full attention, our full participation, and it is ours to create, with nature as our most valued guide. This is what “fully invested” really means. This is the true Nature of Investing.

I would like to beg you
 . . . 
 to 
try to love the questions 
themselves as if they were locked rooms or books  
written in a very foreign language. Don’t search for the 
answers, which could not be given to you now, because 
you would not be able to live them. And the point is to 
live everything. Live the questions now. Perhaps then, 
someday far in the future, you will gradually, without 
even noticing it, live your way into the answer.
—  Ra
iner Maria Rilke

—  Ra
195612 i-x 1-214 r4pm.indd  16 3 2/ 19/14  2: 46:25 AM

1 6 5Timshel: The Power of Choic e1
Thinking is the talking of the soul with itself.2
—  Plato
Throughout this book, one call has sounded time and 
time again: the call to think. Independent, creative engaged thought, when paired with constructive action, is one of our most powerful gifts. Timshel, the title of this chapter, is inspired by John Steinbeck’s East of Eden , where the word’s

meaning is debated. In scripture, “timshel” is part of the verses on Cain and Abel; sometimes it is translated as “thou shalt” (a proclamation), while other times it translates as “do thou” (a commandment). What the character Lee in East of Eden  discovers is a third possibility, one that he 
deems the most accurate: “thou mayest.” Free will. Choice.
To unite thought and action, though, requires two con-

ditions. First, our definitions of thought and action need to be encompassing, with room for emotion and intuition and spirit, too. Second, our underlying values and our guiding principles need to be crystal 
 cl
ear—   ju
st like the honeybees 
195612 i-x 1-214 r4pm.indd  16 5 2/ 19/14  2: 46:25 AM

1 6
6when they’re seeking a new home. Here, then, are my own beliefs.
I believe
 
. . . 
 th
at “and” is better than “or.”
. . . 
 th
at bridges are better than boxes.
. . . 
 th
at the natural world offers insights more 
powerful than those our imaginations could ever create.
.
 . . 
 th
at the systems we create do exactly what 
we designed them to  do
—  an
d that therefore 
we have the power to change them to do dif-ferent, better things.
.
 . . 
 th

.
 . . 
 th
at stories are important. They connect us, 
inspire us, and make the abstract real.
. . . 
 th
at needless fear drives most of the prob-
lems of the world, and necessary fear drives the rest.
.
 . . 
 th
at most people, most of the time, want to 
“bend toward justice.”
. . . 
 th
at extending our time horizon and expand-
ing our focus makes it easier to see true cost and true profit, which naturally leads to more optimized investment decisions.
.
 . . 
 th

.
 . . 
 th
at investment, in its truest and broad-
est sense, is a tremendous force for positive change.
These are my beliefs; they don’t have to be yours. But 
investing our precious 
 re
sources—   ti
me, energy, talents, 
195612 i-x 1-214 r4pm.indd  16 6 2/ 19/14  2: 46:25 AM

1 6 7 wealth—   is an act worthy of deep reflection and considera-
t
ion. Investing is not just a practical necessity; it is embod‑
ied belief. This endeavor is worthy of our full attention, and it is well served by embracing the full spectrum of the world’s 
 wi
sdom—   na
tural, spiritual, emotional, and intel-
lectual. This bank of wisdom is our truest capital, our deepest well, offering endless possibilities for investing in the world that we want to see.

Here we are, on this earth, our home. Together.Surrounded by wisdom and power and potential.Shhhhh.Look. Listen.Welcome home.
195612 i-x 1-214 r4pm.indd  16 7 2/ 19/14  2: 46:25 AM

1 6 9Notes
Saved By the Bee
 1 Th
omas D Seeley, Honeybee Democracy (Princeton, NJ: Prin-
ceton University Press, 2010). See also http://www.cornell.edu/video/honeybee-democracy-book-talk-by-thomas-seeley.
The Roots of Biomimicry Investing
 1 Im
manuel Kant, Critique of Practical Reason (Mineola, NY: 
Dover Publications, Inc. 2004 reprint of 1909 publication by Longmans, Green, and Co. (New York).
 2 Da
yna Baumeister, Biomimicry Resource Handbook: A Seed

Bank of Best Practices (Missoula, MT: Biomimicry 3.8, 2013). See also http://blog.interface.com/category/biomimicry
-8.
 3 Ir
is Marion Young, “Responsibility and Global Labor Justice,” 
Journal of Political Philosophy 12, no. 4 (2004):  36
5–  38
8.
 4 Major resources for biomimicry include: Dayna Baumeister, B io-
mimicry Resource Handbook: A Seed Bank of Best Practices  (Mis-
soula, MT: Biomimicry 3.8, 2013); Janine Benyus, Biomimicry:

Innovation Inspired by Nature  (New York: William Morrow, 1997).
 5 Hazel Henderson and Janine Benyus, “Statement on Transform-i 
ng Finance Based on Ethics and Life’s Principles,” 2012, http://
www.ethicalmarkets.com/statement -on- tr
ansforming-   fin
ance-  
 ba
sed-on- et
hics-  an
d-  li
fes-  pr
inciples.
195612 i-x 1-214 r4pm.indd  16 9 2/ 19/14  2: 46:25 AM

1 7 0N o t e s
Transformation 1: From Efficient to Effective
 1 D.
B. Cater and N.R. Lawrie, “Some Histochemical and Biochemi-
cal Observations on the Preen Gland,” The Journal of  Ph
ysiology 
III (1950):  23
I–  24
3; D. McFarland, A Dictionary of Animal Behav-
iour (New York: Oxford Press, 2006), 163.
 2 G.
J. Tattersall, D.V. Andrade, and A.S. Abe, “Heat Exchange 
from the Toucan Bill Reveals a Controllable Vascular Thermal Radiator,” Science 325: 5939 (2009): 
 46
8–  47
0.
 3 El

46
8–  47
0.
 3 El
ena Tricarico and Francesca Gherardi, “Resource Assessment 
in Hermit Crabs: The Worth of Their Own Shell,” Behavioral 
Ecology 18, no. 3 (2007):  61
5–  62
0.
 4 Yo
seph  Ba
r-  Co
hen, Biomimetics: Biologically Inspired Tech-
nologies (Boca Raton, FL: CRC/Taylor & Francis, 2006). Cited by: http://www.asknature.org/strategy/2765a76a09f7cdbf84c7972ed539a252.
 5 Ja
ck Welch, “Eating and Dreaming,” post for Linked In ,

July 25, 2013, http://www.linkedin.com/today/post/article/ 
 20
130725154204-   86
541065-   ea
ting-  an
d-  dr
eaming.
 6 Go
od Will Hunting, 1997, Gus Van Sant, director.
 7 In
vestment Company Institute, 2013 Investment Company Fact 
Book, 53rd edition (2013),  79 –  80 .
 8 Ch
ristopher Phillips with Francis Kinniry Jr. and Todd Sch-
langer, “The Case for  In
dex-  Fu
nd Investing,” Vanguard , April 
2013. Fund performance data from Morningstar, https://  
per

per
sonal.vanguard.com/pdf/s296.pdf.
 9 Wa
rren Buffett, “Letter to Shareholders,” Berkshire Hathaway 
Annual Report , 2005. http://www.berkshirehathaway.com/
2005ar/2005ar.pdf.
 10 An
drew Ross Sorkin, “Doubts Raised on Value of Investment Con-
sultants to Pensions,” The New York Times , September 30, 2013.
 11 In
 12 Jo
sh Charlson, et al. “  Ta
rget-  Da
te Series Research Paper: 
2013  Su

rget-  Da
2013  Su
rvey,” http://corporate.morningstar.com/us/documents/
ResearchPapers/2013TargetDate.pdf.
195612 i-x 1-214 r4pm.indd  17 0 2/ 19/14  2: 46:25 AM

1 7 1N o t e s
 13 PriceMetrix, T he State of Retail Wealth Management: Third 
Annual Report (February 2013), http://www.pricemetrix.com/cms/wp
-co
ntent /uploads/  Pr
iceMetrix-   I n
sights _T he-  
 St
ate-of- Re
tail-  We
alth-  Ma
nagement-   20
12_English.pdf.
 14 Th
ere is a deep literature on this subject in behavioral finance and 
financial literacy research, including this  me
ta-  an
alysis: Dan-

ta-  an
iel Fernandes, John Lynch, and Richard Netemeyer, “Financial Education and Downstream Financial Behaviors,” forthcoming in Management Science (October 8, 2013). See also http://www.
nytimes.com/2013/10/06/business/
 fi
nancial-   li
teracy-   be
yond-  
 th
e-  cla
ssroom.html?pagewanted=all&_r=0.
 15 Go
kce Sargut and Rita Gunther McGrath, “Learning to Live 
with Complexity,” Harvard Business Review, September 1, 
2011. See also www.santafe.edu.

Transformation 2: From Synthetic to Simple
 1 Jo
hn Pickrell, “Peacock Plumage Secrets Uncovered,” National 
Geographic News, October 17, 2003; Scientific American  306 
(2012),  74
–  79
, published online: 17 April 2012 | doi:10.1038/  
sc
ientificamerican0512 -74
. Also: Philip Ball, “Nature’s Color 
Tricks,” Scientific American  306, no. 5, May 2012,  74
–  79
.
 2 Tr
ee of Life website: tolweb.org/Diatoms/21810, A. Scheffel, N.

Poulsen, S. Shian, N. Kroger, “Nanopatterned Protein Microrings from a Diatom That Direct Silica Morphogenesis,” PNAS 108, no. 8 (2011): 
 31
75–  31
80, http://AskNature.org.
 3 H.
A. Harper, V.W. Rodwell, and P.A. Mayes, Review of 
Physiological Chemistry , 16th ed. (Los Altos, California: Lange 
Medical Publications, 1977), via howthingswork.com.
 4 “T
he Landmarks of  Sn
ake-  Po
ison Literature,” https://play 
.google.com/store/books/details?id=aeoyAQAAMAAJ&rdid =
 bo
ok-  ae

bo
ok-  ae
oyAQAAMAAJ&rdot=1, and “Snake Venom Is Being 
Used To Cure, Rather Than Kill,” http://www.economist.com/news/
 sc
ience-   an
d-  te
chnology/  215
69015-   sn
ake-  ve
nom-  be
ing 
-  us
ed-  cu
re-  ra
ther-   ki
ll-  to
xic-  me
dicine.
195612 i-x 1-214 r4pm.indd  17 1 2/ 19/14  2: 46:25 AM

1 7 2N o t e s
 5 Janine Benyus, B iomimicry: Innovation Inspired by Nature 
(New York: William Morrow, 1997), 7.
 6 Da
vid Robertson and Bill Breen, Brick by Brick: How LEGO 
Rewrote the Rules of Innovation and Conquered the Global Toy Industry (New York: Random House, 2013), [ Au: page 
number(s)?].
 7 It
’s a Wonderful Life, 1946, Frank Capra, director.
 8 El
ena Loutskina,“The Role of Securitization in Bank Liquidity 
and Funding Management,” draft, 2010.
 9 Of

 9 Of
ficial Report, Government Printing Office, “The Financial 
Crisis Inquiry Report: Final Report of the National Commis-sion on the Causes of the Financial and Economic Crisis in the United States.” Washington, D.C.: U.S. Government Printing Office. January, 2011, 70.
 10 Th
ompson Reuters, “Debt Capital Markets Review: Managing 
Underwriters,” first quarter 2013.
 11 Sy
nthetics have an added wrinkle in that they are  zer
o-  su
m: for

this structure to be created, every investor making a positive bet requires another investor to make an equivalent negative bet. This led to numerous moral and ethical questions for securities creators, as motivations for appropriate disclosure and respon-sibility were often at odds with profitability. These transactions are also private and thus unregulated, so it’s hard to find accurate aggregate data. But just one firm, Goldman Sachs, packaged and sold synthetic CDO’s with face value of $66

and sold synthetic CDO’s with face value of $66 billion in the three years ended May 2007. Official

Re
port—   Go
vernment Printing 
Office. “The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States.” Washington, D.C.: U.S. Government Printing Office. January, 2011, 70.
 12 Se
e greenamerica.org or breakupwithyourmegabank.org.
 13 “C
redit Union Earnings Hit  Al
l-  Ti
me High,” March 1, 2013, http://
www.ncua.gov/News/Pages/NW20130301CUEarnings.aspx.

1 7 3N o t e s
Transformation 3: From Maximized to Optimized
 1 Wi
lliam M. Kier and Andrew M. Smith, “The Structure and 
Adhesive Mechanism of Octopus Suckers,” Integrative and 
Comparative Biology 42, no. 6 (2002):  11
46–  11
53, http://dx.doi
.org/10.1093/icb/42.6.1146.
 2 La
urent Keller and Elizabeth Gordon, The Lives of Ants (New 
York: Oxford University Press, 2009), chapters 9 and 10.
 3 “De
clining US High Frequency Trading,” The New York Times ,

October, 15, 2012. Data source: TABB Group, http://www .nytimes.com/interactive/2012/10/15/business/Declining
-US 
- Hi
gh-  Fr
equency-   Tr
ading.html?ref=business.
 4 Th
ere are many versions of these depictions; look for “flash crash 
trading video” and dozens of different representations appear.
 5 US 
CFTC and SEC, “Findings Regarding the Market Events

of May 6, 2010: Report of the Staffs of the CFTC and SEC to the Join Advisory Committee on Emerging Regulatory Issues,” September 30, 2010, http://www.sec.gov/news/studies/2010/
 
ma
rketevents-   re
port.pdf.
 6 Da
n Barnes, “NYSE Flash Crash Reignites the Circuit 
Breaker Debate,” Financial News , June 26, 2013, http://www
.efinancialnews.com/story/2013 -06-26
/ ny
se-  fla
sh-  cr
ash-  re
ignites 
-  ci
rcuit-   br
eaker-   de
bate?ea9c8a2de0ee111045601ab04d673622.
 7 Al

 7 Al
exis C. Madrigal, “No Easy Tech Explanation for What 
Caused Wall St. ‘Flash Crash,’  ” Th
e Atlantic , July 14, 2010, 
http://www.theatlantic.com/technology/archive/2010/07/no
- ea
sy-  te
ch-  ex
planation-   fo
r-  wh
at-  ca
used-   wa
ll-st- fl
ash 
-  cr
ash/59766/.
 8 US 

of May 6, 2010: Report of the Staffs of the CFTC and SEC to the Join Advisory Committee on Emerging Regulatory Issues,” September 30, 2010, 6, http://www.sec.gov/news/studies/2010/
 
ma
port.pdf.
 9 Ju
stin Fox, “The Economics of  We
ll-  Be
ing,” Harvard Busi-
ness Review ,  Ja
nuary–   Fe
bruary 2012, http://hbr.org/2012/01/
 th
e-  ec
onomics -of- we
ll-  be
ing/ar/.
195612 i-x 1-214 r4pm.indd  17 3 2/ 19/14  2: 46:25 AM

1 74N o t e s
 10 Robert F. Kennedy, remarks at the University of Kansas, M 
arch 18, 1968, transcript from the John F. Kennedy Presi-
dential Library and Museum, http://www.jfklibrary.org/Research/
 Re
search-   Ai
ds/ Re
ady-  Re
ference/  RF
K-  Sp
eeches/
Remarks -of-Ro
bert-F-Ke
nnedy -at- th
e-  Un
iversity -of- Ka
nsas 
-  Ma
rch-18-19
68.aspx
 11 Ju
dy Wicks, Good Morning, Beautiful Business: The Unexpected 
Journey of an Activist Entrepreneur and  Lo
cal-  Ec
onomy Pioneer

cal-  Ec
onomy Pioneer 
(White River Junction, VT: Chelsea Green Publishing, 2013), 157.
 12 B-co
rporation, “Declaration of Interdependence,” Accessed 
August 2013. http://www.bcorporation.net/  wh
at-  ar
e-b-co
rps/
the-b- co
rp-  de
claration.
Transformation 4: From Disconnected to Reconnected
 1 P. 
Gorzelak, J. Stolarski, P. Dubois, C. Kopp, and A. Meibom, 
“26Mg Labeling of the Sea Urchin Regenerating Spine: Insights into Echinoderm Biomineralization Process,” Journal of Struc-

tural Biology , 176 (2011): 
 11
9–  12
6, via AskNature.org.
 2 Jo
hn Roach, “No Nemo: Anemones, Not Parents, Protect Clown-
fish,” National Geographic News. Accessed August 27, 2007, via AskNature.org; also J.T. Szczebak, R.P. Henry, F.A. Al
-Ho
rani, and 
N.E. Chadwick, “Anemonefish Oxygenate Their Anemone Hosts at Night,” The Journal of Experimental Biology  216 (2013), 
 97
0–  97
6.
 3 Th
omas Nørgaard and Marie Dacke, “  Fo
g-  Ba
sking Behaviour

g-  Ba
sking Behaviour 
and Water Collection Efficiency in Namib Desert Darkling Bee-tles,” Frontiers in Zoology 7:23 (2010). Also M.K. Seely, C.J. 
Lewis, K.A. O’Brien, and A.E. Suttle, “Fog Response of Ten-ebrionid Beetles in the Namib Desert,” Journal of Arid Environ-
ments 6:2 (1983): 
 13
5–  14
3, via AskNature.org.
 4 A. 
Thornton and K. McAuliffe, Science 313, no. 5784 (July 14, 
2006):  22
7–  22
9.
 5 Ge
neral Electric company website, Investor Relations section,

http://www.ge.com/  in
vestor-   re
lations.
 6 Fe
lix Liechti and others, “First Evidence of a  20
0-  Da
y Non-
stop Flight in a Bird,” Nature Communications  4, article 2554 
195612 i-x 1-214 r4pm.indd  17 4 2/ 19/14  2: 46:25 AM

1 7 5N o t e s
(October 8, 2013). Cited by Smithsonian Magazine , http://blogs
.smithsonianmag.com/science/2013/10/  th
is-  bi
rd-  ca
n-  st
ay-in- fli
ght 
-  fo
r-  si
x-  mo
nths-   st
raight/?utm_source=smithsoniantopic&utm 
_medium=email&utm_campaign=  20
131013-   We
ekender.
 7 Sh
efali Sharma and Steve Suppan, “Commodity Market Dereg-

ulation and Food Prices,” Institute for Agriculture and Trade Policy Presentation at UNCATD Symposium, June 22, 2011, http://www.iatp.org/files/Commodity market deregulation and food prices.pdf.
 8 Ric
k Schmitt, “Prophet and Loss,” Stanford Magazine, March/
April 2009, http://alumni.stanford.edu/get/page/magazine/article/?article_id=30885.
 9 Co
mmodity index fund data from Oliver DeShutter, “Food Com-

modities Speculation and Food Price Crises,” UN Special Rappor-teur on the Right to Food, September, 2010; much of this timeline is abstracted from Ann Berg, “Commodity Funds in Retreat?” special feature in FAO Food Outlook , June 2013: 66
-68
; Frederick 
Kaufman, “The Food Bubble: How Wall Street Starved Millions and Got Away with It,” Harper’s Magazine , June 2010, 
 27
–  34
.
 10 Sh

 11 Fr
ederick Kaufman, “The Food Bubble: How Wall Street 
Starved Millions and Got Away with It,” Harper’s Magazine, 
June 2010, 34.
 12 M. 
Lagi, K. Z. Bertrand, and Y.  Ba
r-  Ya
m, “Food Crises: A

r-  Ya
m, “Food Crises: A 
Quantitative Model of Food Prices Including Speculators and Ethanol Conversion,” September 21, 2011, http://necsi.edu/research/social/food_prices.pdf.
 13 Mic
hael Pollan, “What’s Eating America?” Smithsonian , June 
15, 2006. Also: The Omnivore’s Dilemma: A Natural History 
of Four Meals (New York: Penguin Books, 2007).
 14 M. 
Lagi, K.Z. Bertrand, and Y.  Ba
r-  Ya
m, “The Food Crises 
and Political Instability in North Africa and the Middle East,”

1 7 6N o t e s
arXiv:1108.2455, August 10, 2011, http://necsi.edu/research/social/food_crises.pdf.
 15 “T
he Price of Protest, So Far,” graphic from The Economist , July 
14, 2011, http://www.economist.com/blogs/dailychart/2011/07/ 
 ar
ab-  sp
ring-   de
ath-  to
ll.
 16 Jo
hn Fullerton, “Commodities Are Different,” Capital Institute 
post, August 5, 2013, http://capitalinstitute.org/blog/commodities-  
 are
-  dif
ferent-“  ful
l-  wo
rld”-  par
t-3 
- .UjNYDaXIhwY.
 17 Sl

l-  wo
rld”-  par
t-3 
 17 Sl
ow Money website: http://slowmoney.org.
 18 BA
LLE website: http://bealocalist.org.
 19 Mic
hael Swack, Jack Northrup, and Eric Hangen, “CDFI Indus-
try Analysis Summary Report,” Carsey Institute, Spring 2012.
Transformation 5: From Mechanical to Mindful
 1 Je
nnifer S. Holland, “Living Color,” National Geographic , June 
2008, http://ngm.nationalgeographic.com/2008/06/nudibranchs/   
ho
lland-   te

ho
lland-   te
xt; Terry Gosliner, “Nudibranchs, Corals, and Readers’  
Questions,” The New York Times, Scientist at Work, August 
10, 2010, http://scientistatwork.blogs.nytimes.com/2010/08/10/ 
 nu
dibranchs-   co
rals-  an
d-  re
aders-   qu
estions.
 2 Ref
erenced in Alice Schroeder, The Snowball: Warren Buffett 
and the Business of Life (New York: Bantam Dell, 2008), 201.
 3 Le
slie Christian, former CEO of Portfolio 21, has developed a

framework for portfolio theory to evolve in a way that is more complete and helpful. See Leslie Christian, “A New Foun-dation for Portfolio Management,” RSF Social Finance and Portfolio 21, 2011, http://rsfsocialfinance.org/wp
-co
ntent/
uploads/downloads/2011/10/A - Ne
w-  Fo
undation-   fo
r-  Po
rtfolio 
-  Ma
nagement.pdf.
 4 Wi
ll Danoff, in conversation, sometime around  19
90–  19
91.
 5 IC
I Factbook, 2013, “Number of Funds in the Mutual Fund Indus-

try,” 146. There were over 8000 mutual funds by the year 2000.
 6 Do
n Phillips and Paul Kaplan (Morningstar employees), “The 
Morningstar Approach to Mutual Fund  An
alysis—   Pa
rt II,” in 
Mutual Funds: Portfolio Structures, Analysis, Management, 
195612 i-x 1-214 r4pm.indd  17 6 2/ 19/14  2: 46:25 AM

1 7 7N o t e s
and Stewardship (Hoboken, New Jersey: John Wiley & Sons, Inc., 2010), 
 17
7–  17
8.
 7 Di
ana Del Guercio and Paula Tkac, “Star Power: The Effect

of Morningstar Ratings on Mutual Fund Flows,” November 2003, http://wwwdocs.fce.unsw.edu.au/banking/seminar/2004/Diane%20Del%20Guercio.pdf. Note that this study examined the effect of Morningstar’s “star” ratings, not their categori-zation tool, but the two are intermingled in many publications and, it seems, in the minds of many investors.
 8 IC
I Factbook 2013, “Target Date and Lifestyle Mutual Funds,” 
194.
 9 Fr
ank H. Knight, Risk, Uncertainty, and Profit  (Boston: Houghton

and Mifflin, 1921) Chapter 1; Michael J. Mauboussin, “Interdisci-plinary Perspectives on Risk,” CAS) Mauboussin on Strategy, Legg Mason Capital Management, August 15, 2006; Also: Michael J. Mauboussin, Think Twice (Boston: Harvard Business Press, 2009).). See: http://www.econlib.org/library/Knight/knRUP.html.
 10 ww
w.transitionus.org
Transformation 6: From Static to Dynamic
 1 Th
is quote is attributed to John Maynard Keynes, but an origi-
nal source has not been verified.
 2 Br

 2 Br
ian Switek, “In Evolution’s Race, Horseshoe Crabs Took a 
Slower Pace,” Wired , November 22, 2011. With reference to: 
R. Feldman, et al (2011), “Remarkable Preservation of a New Genus and Species of Limuline Horseshoe Crab from the Cre-taceous of Texas, USA,” Palaeontology 54:6, November 15, 
2011, 
 13
37–  13
46, DOI: 10.1111/j.  14
75-  49
83.2011.01103.x; 
Also: Huxley, T.H. 1877; Also: D. Prothero, Evolution: What the

Fossils Say and Why It Matters  (New York: Columbia University 
Press, 2007)  18
9–  19
1.
 3 L. 
Scott Mills and others, “Camouflage Mismatch in Seasonal 
Coat Color Due to Decreased Snow Duration,” proceedings of the National Academy of Sciences of the United States of Amer-ica 110, no. 18, http://www.pnas.org/content/110/18/7360.
195612 i-x 1-214 r4pm.indd  17 7 2/ 19/14  2: 46:25 AM

1 7 8N o t e s
 4 “Mammoth Genome Project,” Pennsylvania State University, h 
ttp://mammoth.psu.edu/howCloseElephantMammoth.html.
 5 Pe
ter Lynch, Beating the Street (New York: Simon and Schuster, 
1993), 117.
 6 Jer
emy Grantham, “My Sister’s Pension Assets and Agency 
Problems,” April 2012, published on gmo.com.
 7 Vi
viana Zelizer, “Pasts and Futures of Economic Sociology,”

American Behavioral Scientist (2007) 1061, referencing her ear-lier work, The Social Meaning of Money (Princeton, NY: Princ-
eton University Press, 1997) . 
 8 Ed
elman Trust Barometer, 2013, http://www.edelman.com/
insights/  in
tellectual-   pr
operty/  tr
ust-  201
3/ tr
ust-  ac
ross-   se
ctors/
trust-in- fin
ancial-   ser
vices.
 9 Sa
toshi Nakamoto, “Bitcoin: A Peer -to-Pe
er Electronic Cash 
System,” October 31, 2008, http://bitcoin.org/bitcoin.pdf.
 10 Th

10 Th
is summary is largely based on Paul Krugman, “The Inter-
national Role of the Dollar: Theory and Prospect,” National Bureau of Economic Research, 1984: Exchange Rate Theory and Practice, 
 26
3-  26
4, http://nber.org/chapters/c6838.pdf. 
Krugman’s description in turn is largely based on the work of B.J. Cohen, The Future of Sterling as an International Currency 
(London: Macmillan, 1971).
 11 Ba
rry Eichengreen, “Managing a Multiple Reserve Currency

World,” Insight , Volume 8, November 10, 2010.
 12 Th
is commentary builds on some elements of Paul Kemp Rob-
ertson’s TED Talk on Bitcoin. http://www.ted.com/talks/paul_kemp_robertson_bitcoin_sweat_tide_meet_the_future _of_branded_currency.html?source=facebook#.UfZqbzVjjSt .facebook.
 13 Ma
tthew Allen, “Cash Substitute Greases Business Wheels,“ 
Swiss Broadcasting Corporation, October 21, 2009, http://www.swissinfo.ch/eng/business/Cash_substitute_greases _business_wheels.html?cid=7613810.

14 Ja
mes Stodder, “Complementary Credit Networks and 
 Ma
cro-  Ec
onomic Stability: Switzerland’s Wirtschaftsring,” 
June 5, 2009. Appearing in Journal of Economic Behavior & 
195612 i-x 1-214 r4pm.indd  17 8 2/ 19/14  2: 46:25 AM

1 7 9N o t e s
Organization, 72, October, 2009,  79 –  95 , http://ewp.rpi.edu/
hartford/~stoddj/BE/WIR_Update.pdf.
 15 Er
ick Hansch, “Research for the International Independ-
ence Institute, 1972,” notes via the Schumacher Library, via the New Economics Institute, http://neweconomy.net/publications/
 in
itial-  re
sults-   wi
r-  re
search-   sw
itzerland.
 16 Se
e this list via the Schumacher Center for a New Economics: http://
centerforneweconomics.org/content/  ac
tive-  lo
cal-  cu

tive-  lo
cal-  cu
rrencies.
 17 Ro
bin Chase, SXSW Eco Keynote Address, October 2013, 
http://sxsw.com/  mu
sic-  fi
lm-  in
teractive-   sx
sw-  ec
o/news/ 
2013/  wa
tch-  sx
sw-  ec
o-  20
13-  ro
bin-  ch
ase-  ke
ynote.
Biomimicry Investing: Resilient, Regenerative, Reconnected
 1 Jo
siah Stamp, Some Economic Factors in Modern Life (London: 
P.S. King & Son, 1929).
Timshel: The Power of Choice
 1 Jo
hn Steinbeck, East of Eden (New York: Penguin Books, 1952).
 2 Pl

2 Pl
ato, Henry Cary, George Burges, and Henry Davis. The Works 
of Plato , Volume 6 (London: George Bell and Sons, 1902), 247.
195612 i-x 1-214 r4pm.indd  179 2/ 19/14  2: 46:25 AM

1 8 1resources
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McKibben, Bill. Eaarth . New York: Times Books, 2010.
Pollan, Michael. The Omnivore’s Dilemma: A Natural History of 
Four Meals . New York: Penguin Books, 2007.
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1 8 2re s
o u r Ce s
Seeley, Thomas D. Honeybee Democracy . Princeton, NJ: Princeton 
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Seeley, Thomas D. The Wisdom of the Hive . Cambridge, MA: Har-
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1984.
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Graham, Benjamin, with Jason Zweig and Warren Buffett. The Intel-
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-on- tr
ansforming-   fi
nance-  
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sed-on- et
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d-  li
fes-  pr
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sed-on- et
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Press, 2009.
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Sen, Amartya. On Ethics and Economics. Malden, MA: Blackwell, 
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ul Fitoussi. Mis-
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Tasch, Woody. Inquiries into the Nature of Slow Money: Investing 
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1 9 7acknowledgments
Like any good ecosystem, this book has a number of vibrant, intersecting webs and layers of community that have contributed to its creation. Some of these ecosystem species are highly visible and their functions are direct and tangible; others are less apparent and their support is indi-rect, but just as vital, and just as appreciated.
Most directly, I want to thank Janine Benyus and Hazel

Henderson, dear mentors and co-creators of Ethical Bio-mimicry Finance. Both of these women have intellectual rigor, clarity of vision, and warmth of spirit—a rare trifecta of gifts. Their work has formed the rich soil that roots and nourishes the ideas in this book, and their personal sup-port has nourished me throughout the research and writing process.
Along with Janine and Hazel is a growing community

of thinkers and do-ers in biomimimicry and investing, including educators, scientists, business leaders, and more. I am lucky to include Dayna Baumeister, Chris Allen, Beth Rattner, Bryony Schwan, Nicole Hagerman Miller, Toby Herzlich, Erin Leitch, Sherry Ritter, Rosalinda Sanquiche, 
195612 i-x 1-214 r4pm.indd  19 7 2/ 19/14  2: 46:25 AM

1 9 8a CkNo w
l e d g m e Nt s
Lina Constantinovici, Eva Willmann de Donlea, Stuart Williams, Stuart Valentine, and Susan Davis as colleagues, mentors, and friends. Additionally, I benefitted tremen-dously from cross-pollination with my colleagues in the 2013 Biomimicry Specialist cohort, especially Victoria Keziah and Ken McLellan (long live Team SuperOrg!).
In exploring biomimicry investing I have come to

appreciate the power of adaptation more and more, and so I am increasingly grateful for the mentors, colleagues, and friends who have adapted along with me from my perch at Fidelity to my perch at Honeybee Capital. To all of my ecosystem connections who are engaged in investing and finance, especially the giant web of friends from Fidelity, I am deeply indebted. It is thanks to you that I know invest-ing as a noble, valuable profession, not just a business.

ishment, and for me this has been found in people and organizations dedicated to creativity, curiosity, reflection, connection, and rigorous analysis. Thank you to Michael Mauboussin, Andrew Zolli and the PopTech group, the Harvard Divinity School community, the Ohana Invest-ment Circle, and the complexity science networks of the Santa Fe Institute and the New England Complex Systems Institute. All of the authors of material in the Resources section have also provided ongoing insight and

section have also provided ongoing insight and inspiration, some from afar and some from a-near. Raj Panjabi and the team at Last Mile Health, the Common Impact family, and everyone involved with Wellesley College and Habitat for Humanity have helped to re-center my work in service through their inspiring examples.

1 9 9a CkNo w
l e d g m e Nt s
Stephanie Schacht deserves her own shining star on our 
ecosystem map, as she provided research support in every form – philosophical, creative, and analytical. My brother described Stephanie as the one person on earth with the breadth of knowledge and interests needed to simultane-ously research questions like, “What is the best theory on money as an expression of social connection?” and “How much was total CDO issuance in 2Q 2006?” He was right.

One of the most important considerations for 
 ec
osystem 
health is the surrounding environment, the operating con -
di
tions that influence the system day in and day out. I 
am grateful to Jill Friedlander, Erika Heilman,  Sh
evaun 
 Be
tzler, Jill Schoenhaut, and the whole Bibliomotion 
team, for  se
tting remarkably favorable operating condi-
tions throughout this process. Barbara Henricks,  Ma
rgaret 
Kingsbury, Rusty Shelton, and their colleagues at Cave Henricks 
 Sh

Sh
elton, terrific navigators of the media web, 
have ensured that this message is heard. Jurriaan Kamp and Helene De Puy saved the day when we were stumped with title discussions. The fantastic team at Guts & Glory has helped to align belief and practice and visual image for Honeybee Capital in a way that I never imagined possible. Thank you, thank you, thank you.
Dearest to me, I am thankful for my own little subspe-

cies within the ecosystem, my family. When I was seven years old and told my parents I was going to be President of the United States, they did not laugh; that’s pretty much all you need to know about our supportive family environ-ment. My Wellesley sisters—all of them—and my New-ton friends have provided inspiration and connection and 
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2 0 0a CkNo w
l e d g m e Nt s
comfort over long stretches of time and space, cushion-ing some disruptions and gently encouraging others, just exactly as needed. 
Finally, I am grateful for my literal ecosystem, my cor-
ner of Massachusetts full of sugar maples and swampy bogs and bluebirds and rolling hills and honeybees and a big brown thing that lives under the porch. I can’t wait to see what wisdom they will share with me in the time to come.

2 0 1Index
Aabstraction of activity, 62–63abundance, 161Acumen, 131adaptability, 14, 117–136,  
160–161
assessment tools and, 117–122creativity and, 131diversity and, 118, 120, 122evolution of, 131–133evolving to survive and, 144mutual funds and, 125–131pathway to practice of, 133–135reactivity in, 126resilience and, 118, 119–120, 
121–122
self-renewal and integrity in, 118, 
119, 121, 126
sowing seeds of, 135–136style box tool and, 126–129translating to investing,  
123–124

123–124
variation and, 129–130
agency, 22Airbnb, 152alignment, 19–20Allen, Chris, 18Bbank consolidations, 65–66banking, 65–66, 147, 149barter, 145–146, 151–152Baumeister, Dayna, 17, 18B-corp (benefit corporation) 
movement, 91
Benyus, Janine, 9, 17, 18, 54biomimicry framework, 9–11
ancient wisdom in, 17context in, 19efficiency vs. effectiveness and, 
27–47

27–47
evolving to survive, 136–151getting started with, 22–24locally attuned, 95–116mindfulness in, 117–136multilayered approach in, 20philosophy and practice in, 16practice in, 19–24roots of, 13–18scaling with, 20what it is not, 21
Biomimicry Specialist education 
program, 17–18
Bitcoin, 147, 151, 152blame, 17
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2 0 2INd e
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bottom-up activity, 73, 74, 75–77, 
83–84, 87
“Break Up with Your Mega-Bank,” 
65
Buffett, Warren, 38, 121Business Alliance for Local Living 
Economies (BALLE), 113–114
Buzzcar, 152CCalvert Foundation, 45Capital Institute, 111Chase, Robin, 152Cheez Whiz, 50, 67Chicago Board of Trade, 108choice, power of, 165–167closed systems, 142–143, 154collateralized debt obligation 
(CDO), 60–64
collateralized mortgage obligation 
(CMO), 60–64
comfort, 10command-and-control management, 
77

77
commercial traders, 105Commodities Futures Trading 
Commission (CTFC), 85–86
commodities markets, 104–112, 146Commodity Futures Modernization 
Act, 108
Commodity Futures Trading 
Commission (CFTC), 108
community. See also connections
commodities markets and, 
104–112
in finance, 58–59local, attunement with, 95–101mortgage-backed securities and, 60
community agriculture programs, 
132–133
community development financial

132–133
community development financial 
institutions (CDFIs), 114complexity
complication vs., 42–43in mortgage-backed securities, 
60–64
regulatory, 76–77
compliance agreements, 76–77complication
complexity vs., 42–43cost of for investors, 38–42as duplication, 45efficiency and, 47simplicity vs., 49–69through investment helpers, 
36–43
unnecessary, 27–28
connections, 95–116, 159–160

in consumer banking, 65–66cooperation and, 97, 98, 100–101eroded by tools, 4–6growth and, 79for simplicity vs. synthetic 
investing, 57–59
context, 19, 23–24
for effective investing, 34–35growth and, 79local community and, 97, 100, 
115–116
cooperation, 97, 98, 100–101, 116
commodities markets and, 106, 
112
corn, food commodity markets and, 
110–111
creativity, 3–4, 20
adaptability and, 131evolving to survive and, 153–154limits as spur to, 55–56

credit unions, 65crowd funding, 66curiosity, 21currencies, evolution of, 145–151, 
145–153, 155
cyclic processes, 97, 99, 106, 112
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2 0 3INd e
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Ddata gathering, 6, 135–136
open inquiry in, 21reshuffling information and, 139, 
140, 148, 150
Davis, Susan, 132decentralization, 118, 119–120, 
121–122, 136
decision making, 6–9, 11, 162. See 
also investment tools
“Declaration of Interdependence,” 91decomposition into benign 
constituents, 51, 53–54, 61
derivatives, commodities markets, 108development. See growth
diatoms, 52–53diversity, 118, 120, 122, 136
in mutual funds, 126, 129
duplication, 45durability. See resilience

“duration trading” approaches, 136EEast of Eden (Steinbeck), 165economic theory, 15–16Edelman Trust Barometer, 147effectiveness, 27–47
in investing, 33–47of mutual funds, 126, 129pathway to, 45–46purpose and, 36–43relationship with efficiency, 31–32
efficiency, 27–47
connections vs., 4–6in investing, 33–47of mutual funds, 126, 129pathway to practice of, 45–46purpose in, 36–43relationship with effectiveness, 
31–32

31–32
resource, 28–32, 46–47systemic, 46time frame and, 32tools in, 4–6uncertainty and, 133–134
electronic currencies, 147, 151–153embodiment, 141energy efficiency, 28–32engagement, 3–4equity investing, 65ethanol policy, 109–111evolving to survive, 137–155
currency, 145–153, 150definition of success and,  
141–142, 144–145
embodiment of, 141integrating the unexpected and, 
139, 140, 150
open vs. closed systems and, 
142–143
pathway to practice in, 153–154replicating what works and,

139–140, 150
reshuffling information and, 139, 
140, 150
sowing seeds of, 154–155translating to investing, 144–145
exchange, 13, 145–151exploration, 96–97extension of activity, 62–63Ffailure
fast, 88rates of, 141
farmer’s markets, 132–133fear, 142feedback loops
in commodities markets,  
106–107
commodity markets and, 112crucial components of, 99–100in early-stage ventures, 88in high-frequency trading, 87
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2 0 4INd e
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feedback loops ( cont. )
locally attuned, 97, 99–100, 101, 
116
in quarterly earnings releases, 
102–104
resilience and, 135–136style box tool and, 128
Fidelity Magellan Fund, 141–142finance, 13–15financial markets
2008 financial crisis and, 62–63changes in, 3–6commodities, 106–112flash crashes, 81, 84–86reframing, 22–23
financial system
fissures in current, 159–161resilience of, 15

“first loss” investments, 131flash crashes, 81, 84–86flexibility, 10, 14, 160–161food commodities, 107–114Freecycle, 152Fullerton, John, 111“full-spectrum” investing, 131–132function
of currency, 147–148of effective investing, 45–47fitting form to, 29, 30–31, 47of investing, 34–35in mutual funds, 38of mutual funds, 125–131need-based, 30–31, 35–36overloading, 155overshadowed by finance, 13–15simplicity and, 57–58of ultra-helped investment, 42

fund of funds products, 39GGeneral Electric, 103globalization, 97, 104–112gold standard, 145Good Will Hunting, 34Gramm, Leach, Bliley Act, 108Grantham, Jeremy, 142Grantham Mayo van Otterloo, 142Green America, 65growth
of beehives, 78bottom-up, 73, 74, 75–77, 83–84, 
87
changing definitions of, 89–90in early-stage ventures, 88–91evolution of, 88–91high-frequency trading and, 81–87integrated point of view for, 75integrating with development, 
71–94
modular/nested components and, 
73, 83, 87

71–94
73, 83, 87
multidimensional, 89–91optimization vs. maximization of, 
71–94
pathway to practice for, 92–93purpose of, 80self-organized, 73, 74–75, 84, 87sowing seeds of integrated, 93–94translating to investing, 78–81
HHabitat for Humanity, 95–96, 115heat maps, 4–5hedge funds, 39
costs of, 40–41
Henderson, Hazel, 9, 17, 18high-frequency trading, 81–87, 92Honeybee Capital, 9honeybees

adaptability of, 123decision making by, 6–8evolution of to survive, 143integrated growth and 
development by, 78
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life-friendly chemistry by, 54locally attuned, 102resource and energy efficiency of, 
33
Iimpact investing, 44–45, 132–133index funds, 36–37, 39information
locally attuned, 97, 99–100sharing for collective decision 
making, 6–7
inspiration, 10integrated approaches, 10
for growth and development, 
71–94
integrating the unexpected, 139, 
integrity, 118, 119intentions, 153intervention, currency as, 149investing

by actual investors, 66adaptability in, 123–136alignment of with nature, 13biomimicry-based framework for, 
9–11, 13–18
decision making for, 6–9efficiency vs. effectiveness in, 
33–47
as embodied belief, 165–166fissures in current system of, 
159–161
function vs. finance in, 13–15growth and optimization of, 
71–94

71–94
high-frequency trading, 81–87impact, 44–45life-friendly, 56–59locally attuned, 102–114need-based, 35–36, 44–45as profession, 15–18purpose in, 36–43rearranging with nature, 22reframing, 22–23risk management in, 14, 15synthetic vs. simple, 49–69transactional vs. relational, 115ultra-helped, 40–42
investment advisors, 39investment tools, 11, 117–136

complication through, 36–43connections eroded by, 4–6as drivers of investing, 14heat maps, 4–5mutual fund, 125–131reorienting toward resilience, 
134–135
risk management and, 124, 
129–131
style box, 127–128
invoicing, 149It’s a Wonderful Life, 59–60KKant, Immanuel, 13Kennedy, Robert, 89–90Kickstarter, 66Kiva, 66Knight, Frank, 130Lleadership, 76–77LIBOR, 111life-friendly chemistry, 51–54
decomposition into benign 
constituents, 51, 53–54, 64

do chemistry in water, 52–53, 63limits and, 54–56mortgage-backed securities and, 
59–64
selective building with a small 
subset of elements, 51, 53, 63
limitations, 54–56, 131
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2 0 6INd e
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local attunement and responsiveness. 
See also community
commodities markets and, 104–112cooperative relationships and, 97, 
98, 100–101, 106, 112, 116
as dynamic, responsive process, 101evolution of, 112–114evolving to survive and, 144feedback loops/information flows 
and, 97, 99–100, 112, 116
of honeybees, 102leveraging cyclic processes and, 
97, 99, 106, 112
pathway to practice of, 114–115readily available materials/energy 
and, 97–98, 106, 111

sowing seeds of, 115–116translating to investing, 102–104
long-term approach, 137–155
definitions of success and, 
141–142
evolving to survive, 137–143
Lynch Peter, 141–142Mmanagement, 76–77Mauboussin, Michael, 130maximization, optimization vs. See 
optimization
mentors, 88–89modular/nested components, 73, 83, 
87, 88
Morningstar, 127–128mortgage-backed securities, 59–64Mosaic Energy, 66multidimensional perspectives, 
89–91, 121–122
multifunctional design, 28

evolving to survive and, 150–151of mutual funds, 37of ultra-helped investment, 41
multilayered approaches, 20Munger, Charlie, 121mutual funds, 36–38
analytics for, 125–131costs of, 39“go-anywhere,” 125–126style box tool for, 127–129“target date,” 128
Nnature, as model, mentor, measure, 
and muse, 20
need
in investing, 34–35reconnecting investment with, 
44–45
simplicity and, 66–67
New England Complex Systems 
Institute (NECSI), 109–110

New York Stock Exchange, 85nonjudgmental systems, 10nontoxic production, 50–56
mortgage-backed securities and, 
60–64
sowing seeds of, 68–69translating to investing, 56–59
Oopenmindedness, 23–24open systems, 142–143, 154optimism, 161–162optimization, 19, 71–94
bottom-up, 73, 74, 75–77, 83–84, 
87
integrated point of view for, 75integrating growth and 
development for, 71–77
73, 83, 87

73, 83, 87
pathway to practice for, 92–93self-organization and, 73, 74–75, 
84, 87
translating to investing, 78–81
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2 0 7INd e
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Pparticipation, 17patience, 23–24peer collaboration, 152peer-to-peer lending, 44perspectives, 160
multidimensional, 89–91, 121–122romanticized, 10, 21
planning, 76–77Plato, 165Pollan, Michael, 110pollination, 143, 155portfolio theory, 124, 134–135Principles of Ethical Biomimicry 
Finance (Henderson, Benyus, Sanquiche), 18
proactivity, 3–4processes
life-friendly chemistry and, 51–54low-energy, 28, 37, 41of mutual funds, 37in ultra-helped investment, 41

prosperity, definitions of, 89–90purpose
appropriate, 135–136complicated vs. complex, 42–43in effective and efficient investing, 
36–43
efficiency and, 45–46growth and, 80, 92, 93in nontoxic investing, 68–69
Qquarterly earnings releases, 102–104quietness, 23–24Quotron, 4–5Rrearranging, 22recycling, 29, 30
in mutual funds, 38in ultra-helped investment, 41–42redundancy, 118, 119–120,  
refocusing, 133refraining, 23–24reframing, 22–23regenerative systems, 160regulatory systems, 76–77

food commodity markets, 108, 
109–111, 113
relational investing, 115replicating what works, 139–140, 
148, 150
resilience, 10, 14, 160–161
adaptation and, 118, 119–120, 
121–122, 123–124
evolving to survive, 137–155of financial system, 15multidimensional growth and, 
90–91
multidimensionality of, 121–122of mutual funds, 126, 129reorientation toward, 133–135sowing seeds of, 135–136
resource efficiency, 28–32

form and function in, 29, 30–31in investing, 33–36low-energy processes and, 29–30of mutual funds, 37–38recycling and, 29, 30sowing seeds of in investing, 46–47time frame and, 32
responsibility, 17Rilke, Rainer Maria, 163risk and risk management, 14
adaptability vs., 124fear and, 142focus on, 15by measuring it, 129–131portfolio theory on, 134–135resilience and, 135–136uncertainty vs., 129–130, 
133–134
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2 0 8INd e
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romanticized perspectives, 10, 21RSF Social Finance, 45SSanquiche, Rosalinda, 18scalability, 79scale, 20Securities Exchange Commission 
(SEC), 85–86, 87
Seeley, Tom, 6–8self-organization, 73, 74–75, 84, 87self-renewal, 118, 119, 121
in mutual funds, 126, 128–129
self-sustaining activity, 19–20simplicity
bottom-up activity and, 76–77elegance of, 54, 68–69evolution of in investing, 65–66life-friendly chemistry and, 51–54limits and, 54–56mortgage-backed securities and, 
59–64

59–64
nontoxic production and, 50–56pathway to practice in, 66–68sowing seeds of, 68–69synthetic vs., 49–69
Slow Money movement, 113SoCap conference, 132Social Progress Index, 89social unrest, food commodity 
markets and, 110–111
speculation, 14, 107–113“spin class” approach to trading, 82, 
92, 93–94
Stamp, Josiah Charles, 159standardization, 122, 128Steinbeck, John, 165stewardship, 17stockpicking, 39style box tool, 127–128success, definitions of, 141–142,

144–145, 153–154, 155supply and demand, 109–110sustainability, 9, 19synthetic securities, 49–56, 56–57, 
58–59. See also simplicity
TTaskRabbit, 152technology, 4–6, 152–153thinking, 3–4, 11, 165–167time frames
efficiency and, 32long-term, 137–151
timshel, 165–167tools. See investment tools
toxic securities, 50transactional investing, 115Transition Movement, 132transparency, 153TriLinc Global, 45trust, 146–147, 153tulip mania, 35Twinkie portfolios, 66–68Uuncertainty, 129–130, 133–134. See

also risk and risk management
Vvalue, storage of, 148–149value systems, 7, 165–166variation, 118, 119–120, 121–122, 
129–130, 136
Wwaggle dance, 102Welch, Jack, 32, 103White Dog Café, 90–91Wicks, Judy, 90–91WIR, 151–152ZZipcar, 152
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Katherine Collins is Founder and CEO of Honeybee Capital, a research firm focused on pollinating ideas that reconnect investing with the real world. After a long and successful career as head of research and portfolio manager at Fidelity Management & Research Company, Katherine set out to re-integrate her investment philosophy with the broader world, traveling as a pilgrim and volunteer, earning her MTS degree at Harvard Divinity School, and studying biomimicry and the natural world as guides

biomimicry and the natural world as guides for investing in an integrated, regenerative way, in service to our communi-ties and our planet. She lives in Massachusetts with several thousand honeybees.

More details about Katherine, The Nature of Investing, 
and Honeybee Capital can be found at honeybeecapital.com.
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