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ANDREW W. LO: So on
behalf of the Sloan School
I want to welcome all of you
to 15.401 Finance Theory.
This course is meant for
first year MBA students.
And so that's the
focus, and I'm going
to assume that that's the
background that all of you
will have.
We may have a few other
students in the class,
but primarily it will
be first year MBAs who
are thinking about
a career in finance,
as well as those
of you who aren't
sure about a career in finance
but are curious about it.
Hopefully over the
next 13 weeks we'll
be able to satisfy
that curiosity.
I want to start by
talking a little bit
about what finance is, and
how I got interested in it,
because I think it's
often helpful in order
to motivate a subject
to get a sense of how
somebody else decided to
choose this as a profession.
To do that I have to
go back a little bit,
and give you some
background about
my own educational experiences.
So let me start by
mentioning that I've
been at MIT for
the past 20 years,
and been in the finance
group all that time.
Before that I taught at the
Wharton School for four years.
And before that, I got
my PhD in economics
from Harvard University,
and then graduated in 1980
from Yale also
majoring in economics.
And during that time I've
learned an enormous amount
both about finance
and the real world,
but one of the things
that I keep coming back to
is the fact that
the finance field
is almost unique in how it
applies to practical management
problems.
And what I want to try to
do over the next 13 weeks
is to convince you of
the fact that finance
is in fact, the most
important subject
that you'll ever encounter.
That in fact, finance is
at the core of everything
that you will ever do in
business and in management.
Now that's a tall
order I recognize,
and I suspect that
some of you are
quite skeptical about the
role that finance might play
in your own career objectives.
And I know many of you have very
different career objectives.
And I'm not even trying
to convince all of you
to go into a career
in finance, but I
am trying to convince all of
you that finance is really
the lifeblood and
the basic lingua
franca of all of business.
And that's one of the
reasons why finance
is such an important subject.
Now before I begin, let
me ask you a question.
How many people have had no
finance background whatsoever?
Oh, that's great.
I look forward to a challenge.
But the other
reason it's great is
I have to tell you that it's
a real privilege for me to be
here in front of you to
tell you about finance
for the very first time.
And it reminds me a
little bit of my younger
son who is an
extraordinarily fussy eater,
he's eight years old now.
But ever since he was born
he had some allergies,
and he just refused to
eat most of everything.
In fact, my wife often says that
my younger son is a vegetarian
except he doesn't
eat vegetables.
So he's an incredibly
fussy eater,
and somehow when
he was one year old
he saw my older son
eating an ice cream cone,
and figured that that's
something he ought to try.
How he figured that
out, I don't know.
But he tasted it for
the very first time,
and you could see his face
change in about four seconds
from disgust to curiosity
to absolute, you know,
enthrallment with the taste
and feel of ice cream.
He just loved it thereafter.
That's one of his
major food groups now.
It's ice cream.
And so I feel privileged to be
able to share that experience
here in the sense that once
you get a taste of finance,
I think you're going
to be incredibly
excited and enthralled
by the subject.
Because it's one of
the few subjects,
in fact, that's the only
subject that I've encountered
that is both rigorous,
it's extraordinarily
challenging from a research
and intellectual perspective,
and at the end of the day
it's extremely practical.
In fact, I would say
it's indispensable
for financial management.
So I'm going to try to convince
you of that over the next 13
weeks, and I'm going to do
that by going over material
that you will find
indispensable.
As many of you know, at
the end of the course
we have a ritual where we
hand out teaching ratings.
And among the finance faculty,
among all the faculty,
we're very concerned
about good teaching.
So these teaching
ratings actually matter.
And I've always thought that
having a teaching rating
survey at the end
of the semester,
is somewhat misguided.
What I'd like to do,
and what I've proposed
hasn't been adopted
yet, I propose
to have teaching
ratings submitted five
years after a course is done.
Now this may be a problem
for some people who aren't
up to speed in the classroom.
But the reason I say this
is, because it will only
be after you get into your
jobs, into your careers,
before you realize
how useful finance is.
And five years from now,
I suspect all of you
will come back
and say, gee, this
is one of the most important
courses you have ever taken.
Not because of me, but because
of the substance of what
we're going to cover
over the next 13 weeks.
It's because of you
and all of the work
that you will put
into this course.
This will be the most
challenging course
you will ever love.
So I-- stealing
from the military--
I think that you'll
really appreciate
how the discipline
of financial logic
will help you to think smarter
about all of your management
decisions no matter what you
decide to do with your careers.
Now that's a very tall order.
I've built up expectations.
So I'm going to have to
deliver over the next 13 weeks,
and we'll see whether
or not we can do that.
But let me start now
by talking about what
we're going to cover today.
I want to start with a
little bit of motivation,
and then talk about
the dramatis personae.
These are the cast of
characters that we're
going to be focusing on
over the next 13 weeks.
And then I'm going to lay out
the fundamental challenges
of financial analysis.
It turns out there are only two.
There are only two challenges
in financial analysis,
and once you figure both
of those out, you're done.
So if by chance you
can figure that out
before the end of
the class, you don't
need to come back for
the rest of the lectures.
Then I'm going to
turn to providing you
with a framework for thinking
about these financial
challenges.
To me it's very important to
have a framework to start with,
because I like to
organize my thoughts
into things that I know and
things that I don't know.
And of the things that I know,
how did it relate to the stuff
that I already knew,
or thought I knew.
So I want to give you a sense
of that kind of framework
to think about financial
analysis upfront.
You probably won't fully
appreciate it at this point,
but sometime over the next
13 weeks you will get it.
And so I want to
give that to you
so that you can start thinking
about it subconsciously,
unconsciously, and
then eventually you
will understand how all
the pieces fit together.
I then want to talk
about the importance
of two aspects of
financial analysis
that make finance different
from every other discipline you
will ever encounter here
at MIT and elsewhere.
And that is time and risk.
Without those two
factors it turns out
that finance is actually done.
In other words, there's no
real research challenges,
no open questions left once
you eliminate time and risk.
Put in another way,
the only reason
that there exists a finance
department, and finance
faculty, and finance journals,
and a finance industry,
the only reason is
because of time and risk.
So I'm going to
come back to that.
Then I'm going to conclude
by giving you the six
basic principles of finance.
These are principles
that you will encounter
in all of your finance courses
for the rest of your stay
at MIT and elsewhere.
These are the ideas,
the fundamental ideas,
that have shaped
financial markets
and that are at the root cause
of all of the financial market
innovations, as well as all
of the financial market crises
that we've seen including
what's been going on
over the last several months in
the subprime mortgage market.
In fact, we're going to talk
about the subprime mortgage
problems after we cover
fixed income securities.
Right now I suspect
most of you know
that there's something going
on, know that it's bad stuff,
but you don't know
why, how, where, when,
and what to do about it.
Well, in about five
lectures, you will.
It's not complicated, but
it's different from anything
that you've ever encountered.
And in fact, financial
analysis, I suspect,
is different from anything most
of you have ever encountered.
I'm hoping that by
the end of the course,
it will change the way you
think about everything.
And again, I recognize
that that's a tall order,
but you tell me
13 weeks from now
whether or not I've delivered.
And then I'll conclude by
talking about the course
overview, and then
finally I want
to say a few words
about how as a student
you can get the most
out of this course.
This is a part of the
lecture that I've always
felt is critical at the
very start of a course
like this, because there
are a number of challenges
that you will face
over the next 13
weeks regarding this material.
And I've always
thought that it would
be helpful for the instructor
to let me know where
those challenges
might come from,
and what I should do
in advance to prepare
for those challenges.
So I'm going to do that at the
end of this hour and a half.
For next time I'd like you
to read Brealey and Myers,
chapters one and two.
We are going to be covering that
today as well as next Monday.
So please keep up
with your readings.
And at the end of
this lecture, I
will talk a bit about
the course requirements
and other aspects of
the course mechanics.
Any questions?
All right, let me start
with some motivation
about why you might
want to study finance
and why finance is so important.
And I've always found that with
motivation it's really best
to do it in a personal way.
That is, to try to find
an individual or a group
of individuals that personify
a particular discipline
or endeavor.
And so there are
three people that I'd
like to introduce you to.
I suspect you'll know at
least two out of the three,
but my guess is you
won't know all of them.
The first person--
oh, before I do
that, I want to introduce a
very simple definition of what
finance is.
So this is the
very first equation
that you'll ever
see in this course,
and there'll be many
others of course.
But the first expression
of exactly what is finance
is this, finance is simply
equal to mathematics plus money.
Now that suggests that
mathematics as a discipline
is equal to finance
without the money,
but really that's not my point.
Although it's true by the
way, that's not my point.
My point is that
finance is the study,
the systematic and disciplined
study of financial transactions
of money.
Now when you see this you
might think, well, gee,
I don't really have a
strong math background.
Maybe I'm in the wrong
place or the wrong class.
And I want to explain to
you that that's completely
inaccurate, and inappropriate.
When I say mathematics,
I'm actually
talking about a very wide
range of mathematics.
Everything from
the extraordinarily
complex and profound to
the extremely pedestrian
and obvious.
So literally the range
from differential geometry
and partial
differential equations
on one end of the spectrum
to arithmetic and high school
algebra at the other
end of the spectrum.
Now since this is an
introductory finance class,
I assume that you know nothing.
What I mean by that
is, I assume that there
are no prerequisites that you
have other than what it took
for you to get
into here, which is
pretty substantial by the way.
Congratulations to all
of you for getting in.
But we're not
requiring that you have
any background in quantitative
analysis, computers,
upper level mathematics.
So when I say finance is equal
to mathematics plus money,
there's a variety of
kinds of mathematics
that can be appropriate
for creating
an extraordinarily profitable
career in this industry.
And now here are
the three examples.
Anybody know who
James Simons is?
Who is he?
AUDIENCE: Well, I know
about Renaissance.
ANDREW W. LO: You know about
Renaissance Technologies.
Do you know what James
Simons did before he started
Renaissance Technologies?
Yeah.
AUDIENCE: He's a math professor.
ANDREW W. LO: He's a math
professor, that's right.
James Simons is
a math professor.
Well, was a math professor.
In fact, he was quite a
well-known math professor.
When I first heard
of him, it wasn't
because of Renaissance
Technologies,
which is a hedge
fund that he started
about 15 or 20 years ago.
James Simons was a differential
geometer who for many years
was the chairman of
the math department
at Stony Brook in New York.
And he authored with S.S. Chern
a particular field of study
in differential geometry called
Chern-Simons theory, which
has subsequently proved
to be extraordinarily
useful in an area of physics
known as string theory.
Extraordinarily abstract.
And Simon started a hedge
fund about 20 years ago.
And this is probably the single
most successful hedge fund
in the history of the industry
in terms of its performance
record.
Over the course
of 15 or 20 years,
he's put together a track
record that has literally
beaten every other hedge
fund manager's track
record by a lot.
So it's not just a little bit.
He's just sort of way out there.
He's the Michael Phelps
of quantitative investment
strategies.
By the way, just to give you
a sense of how successful
he has been.
In 2006, two years
ago, it was reported
by Institutional
Investor's Alpha Magazine--
this is a trade publication for
the hedge fund industry-- it
was reported that James Simons
was the single most highly
paid hedge fund
manager that year
with a take-home
pay of $1.7 billion.
Now, that's not
wealth, that's income.
That was on his W-2.
That was one year's
compensation.
And he did it--
he did this by building
a quantitative investment
management company with 75
PhDs in mathematics, physics,
computer science, and so on.
And nobody, nobody knows what
he does or how he does it.
It's extraordinarily secret.
But there's no doubt that
he's incredibly successful.
So that's one end
of the spectrum.
That kind of mathematics
can make money,
and can be extraordinarily
relevant financial analysis.
Now at the other end of the
spectrum, we have this guy.
You may have heard of
him, Warren Buffett.
He is currently the
richest man on earth.
In 2008 Forbes ranked him
number one in terms of wealth.
At the time, February of 2008,
he was worth $62 billion.
In fact, in a
private conversation
I was told that when Simons
found out he said, really?
$62 billion?
How did he get that?
It's amazing.
That's an extraordinary amount
of wealth for an individual
to put together.
And what's extraordinary
about it, is how he did it.
As many of you know Warren
Buffett is an investor based
in Omaha, Nebraska.
His office is probably smaller
than many of the conference
rooms here at Sloan.
The number of people he has
working for him, I suspect,
is fewer than many
of you who have
done your startups or plan to.
He's got an extraordinarily
small staff.
Mainly it's Charlie
Munger and him,
and a couple of
secretaries, and maybe
a few accountants here and
there, and lawyers of course.
But what he does is to read
company prospectuses, income
statements, balance sheets.
And with literally
high school arithmetic
he's built this incredible
investment empire
by looking at valuation.
Simple accounting.
Now I say simple accounting,
but there's nothing simple
about what he does.
And so clearly he
has certain skills
that also involve
mathematics, but not
the kind of mathematics
that James Simons uses.
And finally, the
third individual
that I'd like to introduce you
to is this fellow, Jack Welch.
Now again, many of you
know him or know of him.
You know that he actually
teaches a course here at Sloan.
But you may not know
that his PhD was actually
in engineering.
And he started out at
General Electric in 1960.
Became CEO in 1981, and
at that time the revenues
of General Electric was
about $26 billion a year.
So it was already a big
and successful company.
And Jack Welch took
it over in 1981.
At the time there were 400,000
employees for General Electric.
Five years later, there
were 300,000 employees
at General Electric.
He eliminated 100,000 jobs.
That's one of the reasons why he
developed the nickname Neutron
Jack, because like
a neutron bomb,
he eliminated a huge
segment of the population.
But five years later
with 300,000 employees,
he increased the market
value of General Electric
by several fold.
And at the end of his tenure
in 2001, 20 years later,
General Electric's revenues
was not $26 billion,
it was $130 billion.
He increased it by a
factor of 4 and 1/2
over the course of 20 years.
It's an extraordinary
accomplishment
for an individual.
Now why do I put him up here?
It's because one of
the things that Welch
did at General Electric,
one of the things
that he was extraordinarily
good at, was making
good decisions about
investments, making
good decisions about costs,
being able to understand
the language of finance
despite the fact
that he used none of his
PhD skills in his job.
He was an engineer by
training, not a manager.
He didn't go to
management school,
although he did a lot
of executive education
after his PhD.
The reason that I give you
these three cast of characters
is because they are so
different in what they do.
They have such
different backgrounds.
They're all
extraordinarily successful,
but there's one thing in common.
The thing in common is that
they all understand innately,
deeply, fundamentally,
the language of finance.
And what we're going to
cover over the next 13 weeks,
are the very basics.
Things that they
take for granted.
Things that they use on a
daily basis to do their jobs.
So it's not to say that if
you do well in this course
you'll end up being
one of these guys,
but it's certainly a
prerequisite I would say.
There's nobody that's been
successful in business,
truly successful, without having
an understanding, at least
an innate or instinctive
understanding,
of the concepts that we're
going to cover over the next 13
weeks.
So to me, that's exciting.
Now again, I'm not trying
to motivate you by greed.
I'd rather motivate you by
the intellectual challenge
of finance, and there will
be some extraordinarily
challenging ideas.
Ideas that are not natural
for any of you at this point,
but which I hope
will be very natural
at the end of this 13 weeks.
So let me start with
the cast of characters
that we're going to be studying
over the next 13 weeks.
There are going to be four
components of the economy
that we're going to focus on.
Now this is a flow
diagram of the economy.
Since we're at MIT we
have to have flow diagrams
at some point, right?
So here's my version
of a flow diagram.
This is a flow model
of the economy,
and there are four
components that
comprise the financial system.
Households, financial
intermediaries,
non-financial corporations,
and then capital markets.
Now obviously the
economy is comprised
of additional components like
labor markets and product
markets.
We're not going
to focus on that.
Although there are certain
financial aspects of those
markets.
Given that we only
have 13 weeks,
our attention will be spent
on those four components,
and I'm going to cover each
of those four components,
both in parallel and to a
certain degree sequentially,
all right?
So I want you to be
familiar with these four,
because we're
going to be talking
about them interchangeably
at various points in time.
Financial analysis applies
to all of these components
in exactly the same way.
But once you apply them
to the specific context,
the terminology may change,
the particular applications
may look different.
What I'm going to try to
teach you in this 13 weeks
is the underpinning
theories that
unify all of the various
different kinds of ideas.
So these are the four
components that we're
going to be looking
at from now and then.
Now let me talk about the
fundamental challenges
of finance.
I told you that there
are only two, right?
And here they are.
There are two aspects
of financial analysis
that we're going
to be focused on.
The first is the
valuation of assets.
And the second is very simply
the management of assets.
That's it.
That's all there is to it.
Valuing and managing.
And I can tell you
exactly what the managing
part is going to look like.
Managing is going to involve
figuring out which of two
possibilities is more valuable.
And then you know what?
You take the more
valuable option.
That's it.
That's all there is to it.
Figuring out the value, that's
going to be challenging.
So we're going to take
that first challenge
to start with, and try
to understand valuation.
I'm going to argue
that all business
decisions, any kind
of business decision,
involves those two challenges.
Valuing something, and
then once you value it,
make a decision on what you
want to do with that value.
This is why I've
argued that finance
is the most important subject,
because literally any business
decision that you
will ever engage in,
constitutes those
two components.
Valuation and management.
Now valuation is going to
be a challenge by itself,
because it's not at all clear
what value we're talking about.
In other words, what is value?
Is water valuable?
Well, life can't be
sustained without it.
At least carbon
based forms of life.
So water is pretty valuable.
But water is not that expensive.
At least before Poland
Springs came along.
Now what about diamonds?
As far as I know, humans do
not need diamonds to survive,
and yet diamonds are
extraordinarily expensive.
There are certain gems
that are invaluable.
Now how can that be?
Clearly we have to
think more carefully
about what we mean by value.
And of course, once
value is established then
management is
relatively easy to do.
Objectives plus valuations
obviously leads to decisions.
So once you tell me what
you're trying to achieve,
and then you value all
the various different
possibilities, then I can tell
you what the right decision is.
Pick the decision that is the
most valuable for achieving
the objectives that you want.
Now that doesn't
really help a lot
if we can't apply this
to specific contexts,
and come up with specific value.
So I want to hammer
this home, and to do
that I want to talk about how it
is that financial markets helps
us establish value through
the price discovery mechanism.
And to do that, I am going
to do a simple demonstration.
Now when I was growing
up I went to one
of these specialized
high schools
that focused on science.
So we were always getting
these various different kinds
of neat demonstrations of
the Tesla kind of coil.
I've always been very jealous
of these science teachers,
because they have these
cool demonstrations that we
in finance don't.
So I've developed a little
demonstration of my own.
It's a simple one that has to
do with the price discovery
mechanism, and because
I teach two sections,
I'm going to have to
make it a little bit more
involved than normally.
So I need two volunteers.
The first volunteer-- thank you.
I'd like you to take
these two pieces of paper,
these are blank pieces of paper.
On one of them write heads,
and the other write tails.
And then place them face
down, and shuffle them
so you don't know
which is which.
And I need another volunteer who
has a coin that they can flip,
because-- thank you.
So as soon as he's
done, I'm going
to ask you to flip a coin.
Do you have a coin by the way?
AUDIENCE: Yeah.
ANDREW W. LO: OK.
I have two items here.
One of which is going to be
auctioned off in this section,
and the other is going
to be auctioned off
in the later section.
And since I don't know
what your preferences are
for one or the other, I
want to randomize this
so that there's no chance that I
favor one section or the other.
So are you done with that?
You shuffled them.
You don't know which is which.
OK, I'd like you to take
these two face down, and put
one in front of one
of these packages,
and the other in front of
the other face down as well.
While you do that, can you
go ahead and flip your coin?
And as soon as he
puts that on there,
I want you to tell me whether
you flipped heads or tails.
And based upon that,
the particular object
that is chosen will be auctioned
off in this particular section.
OK, go ahead.
What have you got?
AUDIENCE: Tails.
ANDREW W. LO: Tails, OK.
So tails.
This is heads,
and this is tails.
So here is the item that
I'm going to auction off.
Before I do that, I'm
going to ask somebody.
Anybody know what's in here?
Nobody knows what's in that box?
Well, what do you
think its value is?
Zero?
Negative?
Can't be negative, right?
There's limited liabilities.
You can't owe me for
something that's in there.
So good.
We've established
some information.
There's a zero lower bound.
Well, I don't know
what the value is.
So what we're going to do is
we're going to figure it out.
Rather, you're going
to figure it out.
I'm going to auction this
off, and now this is for real.
So don't bid if you can't
pay me, and by the way,
I expect to be paid in cash.
All right?
So I'm serious.
This is a serious game.
So if you don't
want to participate,
you're not prepared to
pay me in cash at the end
of this lecture, do not bid.
All right?
OK, I'm going to open it up.
Anybody want to start
bidding for this item?
AUDIENCE: $1.
ANDREW W. LO: $1.
AUDIENCE: Three.
ANDREW W. LO: $3.
AUDIENCE: $4.
AUDIENCE: Four.
AUDIENCE: Six.
ANDREW W. LO: Six.
AUDIENCE: Five.
ANDREW W. LO: All right,
$6 is the high bid.
Can't do that.
All right, $6 is the high bid.
AUDIENCE: Ten.
AUDIENCE: Ten.
ANDREW W. LO: Ten.
OK, we got two tens here.
You were the first.
So that's your bid.
Your bid is the high bid. $10.
AUDIENCE: 20.
ANDREW W. LO: 20.
We have 20.
Wow!
AUDIENCE: High roller.
ANDREW W. LO: $20.
You do see that this package is
smaller than this one, right?
It's a tiny little thing. $20.
AUDIENCE: 30.
ANDREW W. LO: $30.
$30.
High bid.
Any more than $30?
AUDIENCE: Can I ask
a question, please?
ANDREW W. LO: Yes.
AUDIENCE: Where does
the money-- who gets it?
ANDREW W. LO: I get the money.
That's a great question.
That's a great question.
This is going to go
to the foundation
to support Andrew Lo.
I'm the charity.
So this is not a
charity auction.
This is going to go to me.
By the way, I paid
for these items.
So that's why it's going to go
to reimburse my teaching costs.
AUDIENCE: It's going to
ice cream, [INAUDIBLE]
ANDREW W. LO: Right.
OK, $30 high bid.
Any higher bid than that?
$30?
Nothing higher?
AUDIENCE: 31.
ANDREW W. LO: 31.
AUDIENCE: 35.
ANDREW W. LO: 35.
OK, do I hear 40?
Anybody want to do 40?
$40?
AUDIENCE: I'll give you 40.
ANDREW W. LO: $40.
All right, we've got $40.
Anybody willing to go 45?
$45?
All right.
AUDIENCE: 45.
ANDREW W. LO: $45.
Wow!
OK.
Do we hear 50?
$50?
45 is the high bid.
Anybody for 50?
AUDIENCE: Can I short too?
ANDREW W. LO: No
shorting, sorry.
I'm the only auctioneer here.
$45 is the high bid.
Anybody here 50?
Going once.
Going twice.
All right, sold. $45.
Now you're going
to pay me, right?
AUDIENCE: Yep.
ANDREW W. LO: All right.
We established the value.
It's $45.
That's the market at work.
None of you knew
what was in here.
It could be nothing actually.
But I suspect that you
didn't think it was nothing,
because you bid for it, right?
Moreover, I didn't
let you touch it.
I didn't let you feel it.
I didn't let you shake it.
There was no information
whatsoever other
this very pretty packaging.
And yet somehow
magically you were
able to come up with a value.
Now we could argue whether
that value is good or bad.
But it's a number,
and it's a number that
can now be used for analysis.
Now again, I'm not commenting on
how good or bad the number is.
In a minute we're
going to find out,
because I'm going to open this.
Or let this gentleman here open
it, and see what he bought.
But before he does that, I want
to comment that knowing nothing
without any
information whatsoever,
we've established value.
That's remarkable.
Now it's not true, though,
that there is no information.
In fact, there's a
tremendous amount
of information in this room.
Tremendous amount.
Because you know a
number of things.
You know about the
size of packages.
You know about the fact
that I'm a professor,
and if I really cheat you
then I might get in trouble
with the dean.
There are a number of
constraints that are in place,
and with this audience those
constraints affected the value.
For the next five weeks that's
what we're going to be doing,
is talking about
valuation and trying
to understand how what
just happened happened.
OK, would you like to open
it up, and let us know
what you've got for your $45?
And you'll let me
know whether this
has been a good deal or a
bad deal for you and for me.
Oh, just rip it.
My wife does this all the time.
It drives me crazy.
My sons are just--
AUDIENCE: I'm enjoying
my [INAUDIBLE] $45.
ANDREW W. LO: Fair point.
Fair point.
AUDIENCE: Oohhh!
[APPLAUSE]
ANDREW W. LO: Anybody know what
the retail value of that is?
It's an iPod Nano 4 gig version.
AUDIENCE: 125.
ANDREW W. LO: 149 to be precise.
So you had a good deal.
AUDIENCE: Yeah, yeah.
Thank you.
ANDREW W. LO: You're welcome.
Thank you, because
what we did was
to engage in a price
discovery process
with limited information.
With limited information.
I couldn't get the value out
of that that I wanted to.
I would have loved to
have gotten a bid of $149,
but would any of you be
willing to pay that for a box
with no information at all?
Probably not.
So the lack of transparency,
the lack of information,
actually reduced the
value of that object.
But nevertheless,
it did have a value.
Because some of you were
willing to take a chance
that there might be something
interesting in that package.
That is what we're going to try
to understand over the next 13
weeks, and for the first
five of those weeks
we're going to try
to take it apart.
We're going to try to understand
how it is that the market comes
up with the value.
And it's going to
be a challenge.
This is hard to do,
because just like
if we decided to spend the rest
of the lecture figuring out
how you came up with
a $45 bid, or why you
weren't willing to go to 50.
It's going to be really
hard for us to tease out
all of the thinking that went
into this kind of discussion.
So that's why we
have work to do.
It will be exciting
work, because at the end
we are going to come up with
specific quantitative analysis
that will tell us how
valuation is done.
So that's where we're
going to focus on
for the next few weeks.
Clearly once we
figure out valuation,
we can then focus on management.
And the first
two-thirds of this class
will be focused on valuation.
The last one third will be
focused on taking those ideas,
and applying them to management
contexts like capital budgeting
and risk management.
For valuation, the
kind of questions
that we're going to tackle
are ones that implicitly we
did in just a few minutes here.
It's going to be how are
financial assets valued
versus how should
they be valued,
and is that always the same?
Is it the case that
financial assets
are valued the way
they should be valued,
and what do we even mean
by whether or not it should
be valued in a way or not.
And finally, we're going to
ask the question for valuation,
how well do financial
markets really work?
Can we always rely
on them to work well?
In this case, I
don't know if you
would call this
particular auction
one that worked out well.
Certainly worked
out well for you,
but it didn't work
out well for me.
So in what sense did
it work out well?
Well, it worked out
well in the sense
that if I really wanted
to get rid of that box,
if I really wanted to unload it,
I actually was able to do that.
And I got something for it.
Sight unseen, with no
information whatsoever,
I actually got $45.
Roughly a third of the
value of the asset.
That's actually not too bad.
If you're trying to sell
an asset sight unseen,
and you need to
do it immediately,
a 66% discount is
actually pretty fair.
Now we're going to see
more examples of that
over the next few weeks.
Once we determine value, then
the question is management.
How much should I save or spend?
That's a management
question that all of you
have to deal with at some
point or another in your lives.
What should I buy?
What should I sell?
When should I buy and
sell it, and how should I
finance the transaction?
Those are the problems
of financial analysis
plain and simple.
These are problems that apply
to Jack Welch, to James Simons,
to Warren Buffett, and to you.
And it applies to you not just
from the corporate perspective,
but from a personal
perspective as well.
Every one of you have to
think about these issues
on a daily basis.
And so finance
really is completely
inclusive in the sense that it
applies to virtually everything
that you will ever
encounter in life.
To do that I have to
go over the framework
of financial analysis, and the
starting point is accounting.
Accounting is the language,
the lexicon of finance
in that it's the
beginning of how
to measure economic concepts.
Like profit and loss,
revenues and costs, and so on.
So while many of you may not
have accounting backgrounds,
you will learn a fair bit of
accounting in this course,
just because you're going to
have to in order to understand
the material in the lectures.
So you'll need to get
familiar with the basic terms
of accounting, and
in particular you're
going to have to focus on two
concepts that are probably
alien to you.
The notion of a
stock and a flow.
Now when I say stock, I don't
mean common stock or equities,
I have a different term in mind.
By stock in this context,
I mean the stock of assets.
The level of assets.
And by flow I mean the
rate of change of assets.
You know when I
was in grad school,
we started discussing this
concept on the first day
of macroeconomics, and
then one of the students
in the back of the room
said, excuse me, Professor,
but isn't that just the
distinction between a variable
and its first derivative?
And the professor was a little
bit taken aback and said,
well, yes, that's right.
But let me give you another
way of thinking about it that
is somewhat more intuitive.
And that is, think
about a bathtub,
and think about the
faucet turned on
and the water flowing into it.
The stock is the
level of the water.
The flow is how fast the
water is coming into the tub.
And so after that
explanation the student
still seemed confused,
and so the professor said,
you know what, some people
find bathtubs intuitive,
other people find
derivatives intuitive.
So to each his own.
These two concepts
are extraordinarily
critical to financial analysis.
And accounting counterparts are
nothing more than the balance
sheet and the income statement.
The balance sheet measures the
stock of wealth of a company.
What your assets are, and what
your claims on those assets
or liabilities are.
On the other hand, the flow
of wealth into a company
or out of a company is measured
by the income statement.
This tells you how
much the company
is making per unit
time versus its losses.
So the framework for
financial analysis
that we're going to be
coming back to time and again
is this framework
of a corporation.
A corporation has a
certain set of assets.
It's got claims on those assets,
which are called liabilities.
So this picture, this
snapshot, measures
the level of the bathtub.
But that's not
enough to understand
how a company is doing.
You also have to look at
the income statement, which
tells you the sources of
funds, and the uses of funds
over any time period.
Typically on a quarterly basis.
So we're going to come back to
this concept as the framework
for financial analysis.
And by the way, this is
the sum total of the tools
that Warren Buffett uses for
analyzing his investments.
That's it.
Believe it or not.
Nothing fancier.
So it's an incredibly
powerful set of ideas
if you know how to read it.
That framework when
you think about it
from a corporate financial
decision perspective,
involves making decisions
at five points in time.
Corporate financial
decisions involve
thinking about how to deal with
cash raised from investors.
How to think about cash
invested in real assets,
and how to deal with cash
generated by operations.
How much cash to reinvest,
and how much cash you
give back to your investors.
So from this you
should get the idea
that as a corporate
financial officer
you are focused on
cash, the flow of cash.
In fact, cash you can think of
as the lifeblood of a company.
If you follow the cash,
you will eventually
hit upon every important aspect
of the modern corporation's
operations.
And as a financial
officer, you will
be responsible for
analyzing that flow.
And as a decision maker, as
a leader of a corporation,
you're going to have to make
decisions about that cash flow.
Jack Welch uses the
information to be
able to make those decisions.
But he doesn't just get those
decisions prepackaged for him,
he has to understand
what those numbers mean.
Just like Warren Buffett.
Now the corporate financial
decisions involved,
obviously, have a variety
of different components
from a perspective
of career paths.
From the management perspective
real investment decisions
involve two and three.
So if you're thinking
about investing
in a new division or
a new plant or getting
involved in a new
product area, you've
got to focus on two and three.
On the other hand, if you're
the chief financial officer,
and you're thinking about how
should the company finance
its operations, you're going
to be focused on one and four.
If you're the
board of directors,
and you're deciding how much
to pay out to the shareholders,
you're going to be
thinking about five.
And if you're
engaged in managing
the risks of the
corporation, you're
going to be worried
about one and five.
And ultimately your
objective as a shareholder
and as a manager
of this corporation
is to do well by the owners.
So your objective is to
maximize shareholder wealth,
and the framework
that I've introduced
is going to allow
you to do that.
Now again, this may seem
kind of theoretical to you,
and I realize that.
So I'm going to ask you to
make this more personal.
And to do that, I'm going
to ask you to turn this
into your own personal
household financial decision
making framework.
So I'd like you to
take all of these ideas
and literally apply
them to yourself.
Think about the
cash flows that are
flowing through your own life.
There may not be that much right
now since you're at school,
but believe me, it will grow.
So the household,
this is you, sits in
between real
economic activities.
In other words, your
job, and financial assets
and liabilities, which are all
of the financial transactions
that you deal with.
So this cash flow process that
I outlined for corporations, it
works for you too.
So there's cash raised from
financial institutions, right?
Like student loans or
borrowing or home equity loans.
There's cash invested
in real assets.
What's the biggest real
asset that you are all
investing in right now?
AUDIENCE: Education [INAUDIBLE].
ANDREW W. LO: Exactly.
Human capital, yourselves.
Your own education.
Cash generated by labor supply.
Well, obviously,
when you get a job
you're going to be
generating cash.
Cash consumed and
reinvested in real assets.
So consumed means beer
or pretzels or whatever,
and investing in
real assets means
you invested either in
yourself or you invest it
in a home or your children.
Those are real assets.
Sometimes they're
also real liabilities,
but that's a separate issue.
And finally cash invested
in financial assets.
Most of you may not have
a lot of financial assets
at this point, but you
actually have some.
I suspect 401(k) plans,
retirement, Social Security.
Those are financial assets that
whether you know it or not,
you're invested in.
And so when you think
about management,
think about personal management.
How are you managing yourself?
You've got to think
about real investment.
Consumption and financing,
savings and investment,
risk management, and,
obviously, what is
your overall objective in life?
And what you ought to be doing
is with that objective in mind,
managing your real
and financial assets
to maximize the likelihood of
achieving those objectives.
So what I'm asking you
to do is, I want you
to take this course personally.
I want you to take the ideas.
Every single idea
that I mention,
and whether I tell you to or
not for the next 13 weeks,
I want you to take that
idea and ask the question,
how does that make
my life better off?
How can I use that in my own
personal management activities
to improve the kind of
decisions that I'm making?
Because if you could
do that, if you
learn how to do
that instinctively,
you will then take those
ideas and apply them
to management contexts
in your career.
And it will make
it much more likely
that you'll get more
out of this course
than you otherwise might.
Now there are two other
factors that I describe
that make financial
analysis challenging,
and those two factors
are time and risk.
I've argued before that
without these two elements
finance is complete.
There is no more
research to be done.
There's no more analysis
to be done, and all of you
probably will already be able
to intuit a lot of the decisions
that you're going to
be forced to make.
Because without time-- and
by time I mean decisions
at different points in time--
without time and without
risk financial decisions
actually reduce to basic
micro economic analysis.
If you've taken an undergraduate
course in microeconomics
supply equal
demand, well, you've
learned all there is to learn
about finance without time
and risk.
The only reason that
finance is interesting,
the only challenging
aspects of what we do
are because of time and risk.
The fact that cash flows
now are not the same as cash
flows later, and that time
flows in only one direction.
In about four
lectures, I'm going
to give you an alternative
proof of the theory
of special relativity.
And this proof will
have to do with the fact
that interest rates
are not negative.
It turns out that there's a very
deep philosophical connection
between finance and physics
that we're going to get to.
But this is something that you
don't need to be a physicist
to understand.
In fact, I'd argue
that Warren Buffett,
although he may not be able to
articulate these principles,
these are principles
that are somehow
inbred in his worldview.
He knows that $1 today is
not the same as $1 next year.
And he also knows that
$1 today without risk
is not the same as $1 today
with a little bit of risk.
Even a tiny little bit
of risk, he knows that.
And at the end of this
course, you will too.
So risk we have to talk about
in a much more serious way.
We're not going to get to
that for probably six weeks,
because that's going to take
a whole different set of tools
to understand.
So what I'd like to do for
the first three or four weeks
is to focus on
time and just time,
and then I'm going to bring
in risk once we develop
a little bit more machinery to
understand how to capture risk.
And when we put
these two together,
we're going to get
modern finance.
So that will happen some time
in week six, seven, and eight.
Now finally, I
want to talk about
the fundamental
principles of finance,
and then I'm going to talk
specifically about this course.
There are six fundamental
ideas that finance has come up
with that really will change the
way you think about the world,
and you won't
appreciate it today.
I know that.
But I want to put it into
your subconscious today,
because sometime over
the next 13 weeks,
at least I hope over the next 13
weeks, your face will light up
and you're going
to get it one day.
You're going to
get it in the sense
that you will understand
at that point in time
how these six
principles can be used
to make any financial
decision that you need to make
for the rest of your careers.
The first principle
is pretty obvious.
There is no such
thing as a free lunch.
Actually all of
these principles are
approximations to a
much more complex truth.
So if you really want
to be strict about it,
it should read, there may
be free lunches on occasion,
but there's no such thing
as a free lunch program.
There isn't systematic
free lunches.
You might be able to find
one or two every now and then
if you're lucky and
if you work hard,
but systematic transfers of
wealth for no reason at all
are unlikely.
Second principle.
Other things equal--
and this is a phrase
that you'll hear economists
utter all the time.
And of course, other
things are never equal,
but let's pretend that they are.
Other things equal, individuals
satisfy three characteristics.
They prefer more money to less.
That's often called
non-satiation.
They prefer money
now to money later,
and they prefer less
risk to more risk
when risk is defined properly.
Now I'd argue that
these principles
are in fact fairly universal.
Not that you can't find
exceptions every now and then
for every individual, but by
and large over periods of time
and over a large population
this is generally true.
And if you don't
believe me or if you
know people that don't
satisfy these principles,
please introduce them
to me after class.
I'd like to get to know them,
and do some business with them.
Principle three.
All agents act to further
their own self-interest.
Now again, this is not
to say that there aren't
Mother Teresas out there.
That there aren't people that
care about the general welfare
of the public.
But economists in their
own unique and annoying way
have been able to redefine
preferences to even argue
that Mother Teresa is incredibly
selfish, because her utility
function is the
function-- the utility
function of other people.
And so by doing all
this good, Mother Teresa
was only furthering
her own self-interests.
Isn't she so selfish.
Now, so in a way when the
economist defines preferences,
they almost define
it as a tautology.
But finance makes economics
practical in the sense
that I'll describe in
a few weeks exactly
what kinds of preferences are
actually embodied in decision
making, and why this principle
is more often than not,
a pretty good approximation to
a much more complex reality.
Now the last three
principles I'm not
going to talk about in great
detail, because those really
embody a much
larger set of issues
about economics and finance.
We're going to talk about
those three principles,
but only in the last
lecture oddly enough.
We're going to use them.
We're going to use
these principles,
but in the last
lecture I'm going
to question all of the framework
that I've developed for you,
and show you where
the holes are.
For the first 13
weeks, I'm going
to need you to willingly suspend
your disbelief as we describe
the relatively straightforward
and standardized framework
for thinking about
financial problems.
And in the last
lecture I'm going
to describe to you where the
approximations were made,
and why you need to take
advanced courses in finance
to fill those gaps.
So with that said, let me
now turn to course overview,
and then I'll take questions
about course mechanics.
There are going to be four
sections of the course
as outlined in the syllabus.
The four sections are the
introductory material,
which we've gone over today.
Section B, which we will cover
for the next three or four
lectures is valuation.
Discounting and the mathematics
of net present value.
Pricing stocks, bonds,
futures, forwards, and options,
and the relative
kinds of issues that
come up across those
different asset classes.
Section C will focus on
risk, and introduce risk
into the framework of section B.
So once we complete Section C,
we will then have
focused on time and risk.
And finally section
D will be how
to apply those principles to
problems in corporate finance.
What Jack Welch did
from 1981 to 2001.
How do you take these
ideas, and apply them
to practical circumstances.
And then the last
lecture will be
a lecture-- this is not
the same last lecture
as other last lectures.
I'm not going to die,
but so I don't mean
to call it the final lecture.
That sounds a little ominous.
The idea behind
this last lecture
is to put it all
together, and explain
how these financial
theories interact
with imperfections in the
marketplace, and what is--
or is not good approximations.
Let me talk about
course requirements now.
Obviously the lectures
and the readings,
and attendance and participation
will be an important part
of the course.
We are not going to cover the
entire tome of Brealey, Myers
and Allen.
This is a book, which if dropped
off of a six-story building
could actually kill
somebody if it hit them.
So we can't possibly
cover the entire textbook.
We'll cover selected chapters,
but this is Finance 401,
so it's an introductory course.
And so the readings that you
are going to be responsible for
are the ones that are
outlined on the reading list,
and that I've listed
in every lecture.
So for example,
chapters one and two,
you are now responsible for.
And we will be grading
class participation.
So I expect you to come to
class prepared, and ready
to discuss material,
and possibly
questions that we may have
raised in the previous lecture.
And there will be one
case study that you
will be responsible for
writing up and handing in,
and that will be worth
10% of the grade.
And attendance and participation
will be worth another 10%.
So that's 20% of your grade.
And then finally the
midterm and final exam
will be worth 25% and 55%.
Let me explain a
little bit about how
the midterm and final
exam works, because it's
a little different in
this class than in some
of the other classes.
And by the way,
this grading scheme
and the particular
mechanisms are
identical in these two
sections that I teach,
and in the sections that
Professor Wang teaches.
So he and I have coordinated
to have the same approach, so
as not to advantage or
disadvantage any one section.
In your readings packet will
be a collection of problems
that we've put together.
And actually I don't know
if it's in there right now
or if it's being
photocopied, but we
will prepare a list of
problems that you can work on.
These are completely optional.
And there are far too
many problems for you
to be able to do even
in one full semester.
The reason we give
them to you is,
because the only way to learn
finance is to do finance.
If you come into
the class and listen
to my lectures you
may be entertained
for an hour and a half, you
won't learn the material.
In fact, I've now changed the
way I talk about the course,
and I don't describe what
I do as teaching anymore.
Because teaching implies that
I can force feed knowledge
into your brains.
It turns out it can't be done.
And my two sons have proven
that to me time and again.
You have to want to
learn the material,
so you have to pull the
knowledge from me into you.
In other words, you have to
be an active participant.
My 12th grade math teacher
used to say that mathematics
is not a spectator sport.
That's the same for finance.
Finance is not a
spectator sport.
You actually have to do it.
You have to confront yourself
with problems time and again,
and think about how to apply
the principles in our lecture
to those problems.
The purpose of a lecture is
to give you the motivation,
and take you through the
most difficult aspects
of the principles and the
theories of financial analysis.
But it's your job
to do the analysis.
And to that end we're going
to give you some motivation.
And the motivation is that the
midterm and the final exams
are structured so that
most of the weight
is placed on the final.
The reason is the
final is cumulative.
So it's going to cover twice
the material as the midterm.
Therefore it should be
worth roughly double.
But the other reason is
that financial analysis
is alien to the typical
human cognitive process.
None of you are hard wired to
engage in net present value
calculations.
And so it's going to take
some time before you get it,
before it sinks in.
And I've taught this
class many times
before, and usually somewhere
between week eight and week 13
a light goes off in your
head, and you get it.
And I see this by
the bright smiles
on your face around that time.
It could be because
you're getting
to the end of the
semester, and you're
glad to be done with the class.
But I like to think that
it's because at some point
you actually get it.
In a few rare cases
it happens at week 14,
which is not so
good, but hopefully
before the final exam.
Now in order to provide you with
extra incentive to do problems,
and given this is an MBA class,
I realize that all of you
have very busy
schedules, and you
can schedule your own
activities better than we can.
So rather than have weekly
problem sets that are due,
and you have to hand them in,
we have to hand them back.
It's a hassle for everybody.
There are no problem
sets in this class.
None.
However, we're going to give
you a package of problems
and solutions upfront.
You'll get that within
the next few days.
And I will promise you that
the majority of exam questions
will come verbatim from
this package of problems.
Majority.
Meaning more than
50% of the points
will come from the package.
So if all you did was to
memorize this entire stack,
you could ace the course.
But of course,
that would mean you
would spend enormous
amounts of time
in finance, which is not
such a bad outcome either.
So we want to do
this to eliminate
a lot of the fear and anxiety
with financial analysis.
It is challenging, but
it's a lot of fun too.
We want you to have
fun, because that's
the only way you're going
to learn this material well.
So it's up to you as to
how much you want to do.
The recitations will
cover selected problems.
So you're not going to
be left on your own.
The recitations will go over
problems and how to solve them.
I'll do a few in
class, the ones that
are particularly
challenging, but then you'll
need to do more on your own.
And if you do that, you will
be prepared for the final exam
better than most.
The other material will be
readings and lecture material,
and therefore there will
be some customization,
because my lecture style
is different from Professor
Wang's.
But the majority of the
exam will be identical,
and it will be drawn
from these problem banks
that you're going to get
a copy of in advance.
Now frankly, I have to tell
you that I don't really
like to give grades at all,
but I'm forced to do so.
And so that's why we set up this
process for assigning grades.
In fact, a few
years ago, I came up
with what I thought was a
brilliant way to assign grades,
but I haven't been able to
convince the dean's office
to let me do that.
And you know what it is?
It goes like this.
Let me show you.
I propose to give everybody
in this class a B. That's it.
Everybody gets a B.
Now before I do this,
how many people
would object to that?
Raise your hand.
All right, those of you with
your hands up, you get As.
Done.
You see how brilliant that is?
I get a grade distribution.
No work.
The only problem is
it only works once.
And when you're teaching
two sections, so
somehow the second section,
it doesn't work as well.
So I'm sorry I have
to give grades.
You're all adults.
I realize that.
But nevertheless, this
is a necessary part
of the curriculum.
So that's how we're going
to be assigning grades.
In the last four
minutes, and I think
I'm going to try to keep on
time for the entire semester
so we end at five
before the half hour,
and we start five
after the hour.
In the last four minutes,
I want to tell you
a little bit about how to get
the most out of this course.
And we can take this up next
time if you've got questions,
but I want you to spend
time thinking about this.
Most of this course will
be devoted to theory.
But finance is not a
theoretical subject
unlike algebraic topology.
That's a theoretical subject.
I've never heard anybody
become a practical or applied
algebraic topologist.
Finance on the
other hand, there's
no finance without practice.
So while the course will
be focused on the theory,
I need you to think about
the practical elements of it,
and I'm going to help you in
a couple of different ways.
One is by problems,
but the other
is to encourage you to sit
in on a pro-seminar called
the Practice of Finance.
This is a new pro-seminar
that we're launching.
September 17 is
the first meeting.
It doesn't carry any units,
so you can come and go
as you please.
But it'll give you a sense
of the practical aspects
of the industry, and in
particular information
about the career
aspects of the industry
like what are starting salaries
for financial analysts.
Or how do I get a job
in finance if I don't
have any background in it.
It'll go through
those kinds of issues.
So I'd encourage you
to keep that in mind.
The second thing is with
respect to the course,
I will give you lecture
notes ahead of time
for all of the lectures.
I expect you to take a
look at them in advance.
Just skim them.
You don't have to
read them, and try
to sort out what I'm saying.
But I want you to
skim it at least.
And then in class I urge
you to take lots of notes,
because the lecture notes
are not meant to be complete.
In fact, they are
purposefully incomplete
so that you have
to use your hand
and write down your
impressions of the material
as I'm speaking.
Because in that method,
you will actually
absorb more of the material,
and it'll stay with you longer.
I would urge you to review
the lectures afterwards.
Review what I said.
Because you may have
heard what I said,
but you may not have
understood what I said,
and you may not be able
to apply what I said.
So you need to spend time
afterwards soaking it in.
I urge you to work
on the assignments
in groups, but also alone.
Because when you do the
midterm and final exams,
you'll be doing them alone.
So do both.
Don't just assume that you
can do the same in groups
what you will do alone.
And finally, I would ask you
to ask plenty of questions.
I'm going to manage
the class discussion.
So that if we have time, I'd be
happy to talk about issues that
are current and on your mind.
Even whether or not you should
refinance your auto loan.
We're happy to take those
kind of questions assuming
that it's apropos, and
that we have the time
to be able to cover that.
I want you to get engaged.
I want you to take
this course personally,
because that's the
only way you're going
to really learn the material.
All right, thank you very much.
We're out of time.
We'll see you next Monday.
