SOME THINK FAST SOME SLOW JUST THINK SIC

SOME THINK FAST, SOME SLOW

JUST THINK! SIC PRESENTATION, 9/12/2013

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

OMG ? ?

EXAMPLE • I own 5, 000 shares of IBM, worth about $1, 000. • Hedge drop in price, long 50 put contracts, X = 170, price of $0. 27 per share (put contract = 100 shares) • Long side, notional value $1, 000 • Short side, notional value $1, 000 • Short side was dealer putting a bigger deal together, buys an offsetting put, X = 170, for $0. 25 per share • Long side, notional value $1, 000 • Short side, notional value $1, 000 • Short side is a PE firm with a short position on 50, 000 shares sold @ $200 (ignoring rest of hedge).

EXAMPLE • Finally, price of IBM drops to $185 a share. I sell my 5, 000 shares of IBM, for $925, 000. And to eliminate my put, I entering into an offsetting put, price is now $7. 00 per share (netting me $35, 000). • Short side, notional value $925, 000 • Long side, notional value $925, 000 • Total derivatives outstanding (notional amount) is $5, 850, 000. Note that $3, 850, 000 is perfectly offsetting (no risk to system). Remaining short is covered by short position (net no risk).

EXAMPLE • 5, 000 shares of IBM, worth $925, 000. • Total derivatives outstanding (notional amount) is $5, 850, 000. • Appears that derivatives market is 6. 32 times the size of the asset market. • And none of this has anything to do with GDP!

THE ASSET APPROACH http: //www. zerohedge. com/news/2013 -03 -07/us-households-have-never-been-more-reliant-stock-market-their-net-worth

COMMERCIAL REAL ESTATE

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

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

HOW DOES GDP PLAY? MLB postseason chances • http: //mlb. com/mlb/standings/probability. jsp

WHERE HAVE IPOS GONE?

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

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

IMPLICATIONS? • Popular view: fix SEC, Wall Street, etc. • Jay’s view: fewer investor protections can potentially result in more fraud • Eg. , S. 1791 “Democratizing Access to Capital Act of 2011” and S. 1970 “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2011”

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

OPTIONS EXPENSING • Think about Cisco example • $2. 6 billion profit cut in half. Implications for the firm? • Does this “expense” smell right? • What do all other expenses have in common? • Do options?

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

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

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