Chapter 9 If you hold shares in a corporation and management decides

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Chapter 9/Securities, Business Finance, and the Economy: The Tail that Wags the

Dog?

CHAPTER 9

SECURITIES, BUSINESS FINANCE, AND THE

ECONOMY: THE TAIL THAT WAGS THE DOG?

TEST YOURSELF

1. Suppose that interest rates are 6 percent in the economy and a safe bond promises to pay

$3 per year in interest forever. What do you think the price of the bond will be? Why?

The value of the bond times the interest rate (0.06) equals the annual payment

2. Suppose that in the economy described in Test Yourself Question 1, interest rates

suddenly fall to 3 percent. What will happen to the price of the bond that pays $3 per

year?

In this case, the price of the bond will rise; the new price will be $3.00/0.03 =

3. For whom are stocks riskier than bonds? For whom are bonds riskier than stocks?

4. Explain the role of subprime mortgages and mortgage-based securities in the financial

crisis of 2007–2009.

Subprime mortgages to borrowers with limited abilities to repay were packages

and sold to financial institutions as mortgage-backed securities in an effort to diversify

5. Jenny purchases some stocks of Company X that initially cost $1,000 and pays for

them in cash. Jim makes the same purchase but leverages his investment by borrowing

$500 for the purpose at 10 percent interest, using the stocks as security for repayment.

If the stock’s price rises 20 percent, how much money do Jenny and Jim each make on

their investments? If the stock declines in value by 20 percent, how much money will

Jenny and Jim each have? (Remember that, in both instances, Jim must repay his $500

loan with interest.)

When the price of the stock rises by 20 percent, Jenny makes $200 on top of her original

$1,000 investment—a 20 percent profit on her investment. Jim’s investment also makes a

6. If the price of a company’s stock constitutes a random walk, next year its price will

equal today’s price plus what?

DISCUSSION QUESTIONS

1. If you hold shares in a corporation and management decides to plow back the

company’s earnings some year instead of paying dividends, what are the advantages

and disadvantages to you?

The disadvantage of the plowback is that you do not get the cash income that you

might like, in the form of dividends. The advantage is that if the firm invests the funds

2. Show in diagrams that if a speculator were to buy when price is high and sell when

price is low, he would increase price fluctuations. Why would it be in his best interest

not to do so? (Hint: Draw two supply-demand diagrams, one for the high-price period

and one for the low-price period. How would the speculator’s activities affect these

diagrams?)

Figure 1(a) shows a high price, Pa1, while Figure 1(b) shows a low price, Pb1. In

(a), if speculation raises demand from Da1 to Da2, the price will rise to Pa2, while in (b),

Chapter 9/Securities, Business Finance, and the Economy: The Tail that Wags the

Dog?

3. If stock prices really do take a random walk, can you nevertheless think of good

reasons for getting professional advice before investing?

If stock prices really are a random walk, a professional advisor will not be able to

4. Hostile takeovers often end up in court when management attempts to block such a

maneuver and raiders accuse management of selfishly sacrificing the stockholders’

interests. The courts often look askance at “coercive” offers by raiders—an offer to

buy, say, 20 percent of the company’s stock by a certain date from the first

stockholders who offer to sell. By contrast, they take a more favorable attitude toward

“noncoercive” offers to buy any and all stock supplied at announced prices. Do you

think the courts are right to reject “coercive offers” and prevent management from

blocking “noncoercive” offers? Why?

Students will have various answers to this question. The argument against

“coercive” offers is that stockholders may feel pressured to make a decision to sell earlier

5. Discuss “herd behavior” among investors. Explain how it can sometimes take what

would otherwise have been a modest fall in the price of the stocks of a single company

and transform that into a precipitate collapse in the price of many stocks.

Chapter 9/Securities, Business Finance, and the Economy: The Tail that Wags the

Dog?

When a few investors begin to sell off stocks it can lead to other investors

6. Some observers claim that laxity of the rules governing the creation, sale, and purchase

of some types of securities bear much of the guilt for the Great Recession of the early

twenty-first century. Can you suggest some specific types of activity that may bear

much of this responsibility? Explain how these activities may have increased the

problem, and suggest rules that could have reduced the severity of the financial crisis

of 2007–2009 and ensuing recession.

Answers may vary. Responses could focus on banking regulations and

government requirements on lending including loan-to-value and debt-to-income ratios.

APPENDIX

TEST YOURSELF

1. Company A sells heaters and Company B sells air conditioners. Which is the safer

investment, Company A stock, Company B stock, or a portfolio containing half of each?

Ultimately the answer to this question depends on whether or not either of these

2. If you make a lucky prediction about the prices of the stocks of the two companies in

Question 1, will you earn more or less if you invest in that company rather than the

portfolio?

If you make a lucky prediction about the weather trend or other trends within the

DISCUSSION QUESTIONS

1. In program trading, computers decide when to buy or sell stocks on behalf of large,

institutional investors. The computers then carry out those transactions with electronic

speed. Critics claim that this practice is a major reason why stock prices rose and fell

sharply in the 1980s. Is this idea plausible? Why or why not?

The idea is plausible because a very fast fall in demand, as guided by the