II.

Fundamentals of Financial Markets Processes

In this unit, we are going to explore the fundamentals of financial markets processes by the use of
experimental economics,1 and by the examples of bonds and stocks.

A. Dynamic Interaction of Supply and Demand

Watch Margin Call (2011) - Fire Sale of Mortgage Bonds (Wall Street Investment Bank Trading) [HD
1080p] - YouTube and read the transcript:

- City, this is Eric. - Give me Elliot - City. - Hey, it's Will Emerson. - William, how are you? - I'm all
right. - How's the trouble and strife? - Busting my ass, as always. -You see, that's what I tried to tell
you, John. Why do you think I'm single? - I know you did. What can I do for you? - Listen. I just got
the tap on my shoulder,and we've got some risk over here that we need to move. So today it looks like
my loss is your gain. - What kind of size are we talking? - It should be on your screen. I just sent it. -
Jesus! Where does this land? - 96 on the dollar.- 91. - All three and we're done at 94.- Ninety-three and
a half. - Done.

- Hello, gorgeous. -Will, what's happening over there? - Well, today's moving day. - What the fuck are
you guys so worked up about? - You think they tell me anything? All I know is that today, my loss is
your gain. Now you're friendly, so I've come to you first. I got 270 mil at 15 year paying out a point and
a half above par. - Where's it from? - Where's it from? Do you care? - No, not really. Now, where's the
trade? I 'm hearing things...- Alexis...- You guys are scaring me a little... - I'm only sharing this with you
right now. 85. - Done.

- Deutsche.- It's Will Emerson. -Fuck you, you limey bastard. Come on, are you still angry about that?
- Word is out. I'm hanging up now.

- Merrill. - Lawrence! - What the fuck are you guys doing over there? - Just a little spring cleaning.
- That is not what I'm hearing. 2 - All right, Lawrence, are you a buyer? - I'm not sure any more. Where
at? - Well, it sounds like I should be asking you where at. - What are we talking about here? - Three
hundred seventy-five mil at 30 year mixed. - Fuck me. - Are you with me on this? - Sixty-three cents.
- Oh, fuck you. I'm hanging up. - Sixty-three. - Let me call my man here. I'll come back to you in five.
- It may be 55 in five. - Well, all right, then...stay on the line.

- Sam, pick up the phone... Sam, get on the line! - Yeah.- I got Lawrence at Merrill.- Where are we?
- Sixty-three cents. Jesus. On what? - 375 mix 30. - Get him to 65 and hit it. - Are you fucking kidding
me? That's...What is that? That's a $131million loss on a single trade. - I understand. Hit it.
- Hey Lawrence. We're fill or kill at 65. - It's filled.

1. "Vernon Smith has laid the foundation for the field of experimental economics. He has developed an array of
experimental methods, setting standards for what constitutes a reliable laboratory experiment in economics. In his own
experimental work, he has demonstrated the importance of alternative market institutions, e.g., how the revenue expected by
a seller depends on the choice of auction method. Smith has also spearheaded “wind-tunnel tests”, where trials of new,
alternative market designs – e.g., when deregulating electricity markets – are carried out in the lab before being
implemented in practice. His work has been instrumental in establishing experiments as an essential tool in empirical
economic analysis." The Prize in Economic Sciences 2002 - Press release (nobelprize.org)
2. Revealed preference, "actions speak louder than words" and "talk is cheap", Judgement of Solomon - Wikipedia

1
 1. The Equilibrium Model

The equilibrium model of supply and demand explains the process of exchanges depicted in the movie
scene above. The experiments in class serve to teach that model, applied to financial markets, and to
illustrate their explanatory and predictive power.

To understand the relation between supply, demand, and market prices, also watch The Equilibrium
Price | Microeconomics Videos (mru.org) at https://mru.org/courses/principles-economics-
microeconomics/equilibrium-price-supply-demand-example.

Also make sure you can answer the questions at The Demand Curve Practice Questions | Marginal
Revolution University (mru.org) , The Supply Curve Practice Questions | Marginal Revolution
University (mru.org) , and The Equilibrium Price and Quantity Practice Questions | Marginal
Revolution University (mru.org) at https://mru.org/practice-questions/equilibrium-price-and-quantity-
practice-questions

The Equilibrium Model | Microeconomics Videos (mru.org) at https://mru.org/courses/principles-

economics-microeconomics/does-equilibrium-model-work explains our class experiments.

2. The Sunk Cost Fallacy

A key concept in the equilibrium model is the willingness to buy (or sell). Here, we need to guard
ourselves against a common fallacy that will distort our own decisions as investors and our
understanding of how other market participants in financial markets are going to behave - the sunk cost
fallacy. Watch Sunk Costs: The Big Misconception About Most Investments - YouTube at
https://www.youtube.com/watch?v=jJajz9n9Oi4

The willingness of a rational market participant to buy or sell depends entirely on the costs and benefits
in the present and in the future; past costs are "sunk" and irrelevant in a rational cost-benefit analysis,
be it for the barter of a fish for a coconut, the selling and buying of real estate or of financial assets like
shares of stock or mortgage bonds. Consider the following question:

Blackbeard has bought Mary's pub for a price of $100. One year later, he is considering how to
proceed with this investment. Which of the following statements is wrong if Blackbeard only cares
about maximizing the net present value of his investments?

a) Whether Blackbeard should keep or sell the pub does not at all depend on the price he paid in the
past.

b) The opportunity costs of investing in the pub for one year are sunk.

c) Whether Blackbeard should keep or sell the pub depends on the present value of keeping it as
compared to the present value of selling it and shifting the proceeds to alternative investments.

d) If he can sell for more than the original price, he should sell; if not, he should keep it.

2
Explanation: The best and shortest definition for “sunk costs” is “costs irrelevant in a rational cost-
benefit analyis” – like our net present value calculations. “Sunk” is simply metaphorical for “past”. The
counter-intuitive insight to gain from the question is that all past costs are sunk in the sense that they
are not relevant for a rationally acting person – even if they are not “sunk” in the sense of “wasted” on
a bad investment. Why is that? Because a decision in the present can only be a choice between present
and future costs and benefits. We cannot turn back the hands of time. Where we have no choice, there
are no relevant costs.

A thought experiment clarifies this: Imagine a 100 dollar bill that can somehow only buy one specific
item, say a concert seat; we cannot even sell it to someone else. Spending this peculiar dollar bill
doesn't cost us anything really (attending the concert does cost us the benefit of the alternatives
foregone during that time, of course, ). We care about the money we spend not because of the money in
and of itself, but because of the opportunities foregone by spending it – whether in the present or the
future.

The past, of course, is the complete absence of choice. The English language expresses this in the
idiom “Don’t Cry Over Spilled Milk”, meaning “there is no use in being upset over situations that have
already happened and cannot be changed”3. In finance and business, that wisdom translates into another
idiom, “don’t throw good money after bad”, in other words, don't sacrifice the good opportunities of
your present and your future to the bad choices of your past.4

That it is psychologically costly to abandon an undertaking in which we have invested a lot is an

important, but distinct aspect.5 An extreme example might clarify the following more abstract
considerations: Blackbeard has bought the pub for $100 in the expectation of high profits, be it by
running the business or by reselling it at a much higher price. After one year, rather modest profits
seem more likely and real estate prices fallen substantially. Accordingly, he can sell the pub only for
$50. But his buddy Calico Jack has a very promising treasure map and offers Blackbeard a share in the
treasure hunt. Blackbeard should sell and reinvest in the treasure hunt.

That costs incurred in the past do not matter for present decision-making is also implicit in the
discounted cash flow formula that we use to calculate the total present value and net present value of
future cash flows. Only present and future cash flows are relevant. This is best illustrated by a timeline.
Any cash flows before the point representing the present don't show up in the formula. The initial cost
of the investment is always a present cost, present at the time of the decision about alternative
investments.

3. https://www.languagecouncils.sg/goodenglish/resources/idioms/dont-cry-over-spilled-milk
4. Perhaps not surprisingly, the lyrics of a song titled “Hands of Time” express the idea of sunk costs quite well. Might the
singer have commited a sunk cost fallacy? (song at https://www.youtube.com/watch?v=vSW1kUtuVQk)

“I really never felt quite the same

Since I've lost what I had to gain
No one to blame, no one to blame

Seems to me, can't turn back the hands of time

Oh, it seems to me, can't turn back the hands of time”
5. The same holds true for accounting considerations (for those interested see
https://www.accountingtools.com/articles/what-is-a-sunk-cost.html).

3
 B. Financial Assets

Watch Financial Asset Definition and Liquid vs. Illiquid Types (investopedia.com) at
https://www.investopedia.com/terms/f/financialasset.asp to get an idea of what is understood by the
term financial asset.

We are going to look at three important types of financial assets: bonds, stocks, and futures.6

1. Bonds

Old Government Bond with Coupons7

Large format at https://oldetymecollectibles.com/CSA_B-312.JPG

Bonds are just loans, the only reason people get confused about them is that they are shrouded in
peculiar terminology and that the perspective from which we look at their cash flow structure is
different. With normal loans, we usually start to think about the principal, that is the initial sum we lend
or borrow, and then consider the future payments we have to make or want to get, depending on the
interest rate and method of amortization (amortization is paying off the principal, in contrast to paying
off accrued interest).

6. For completeness' sake, "an option is a contract which conveys to its owner, the holder, the right, but not the obligation,
to buy or sell a specific quantity of an underlying asset or instrument at a specified strike price on or before a specified date,
depending on the style of the option. Options are typically acquired by purchase, as a form of compensation, or as part of a
complex financial transaction" (wikipedia). For Employee Stock Options, watch Employee Stock Options (ESOs): A
Complete Guide (investopedia.com) at https://www.investopedia.com/terms/e/eso.asp
7. From the Era: Sentiment vs. Economics at All We Got Is Cotton, Slaves, and ARROGANCE! - YouTube at
https://www.youtube.com/watch?v=S72nI4Ex_E0

4
With bonds, we have to start our considerations and calculations with the face value. That's the amount
the bond issuer pays at the date of maturity. Next we consider the coupon, that is the periodical
payment the bond pays, expressed as a percentage of the face value. It is usually fixed and semi-annual
or annual. Only then does the issue price come into view, and in particular the price at which the bond
is traded after issuance.

Note that the face value is not necessarily and not even typically the issue price! In particular once the
bond is issued, it will be traded at prices above the face value (at a premium), or below (at a discount).
If it is indeed issued or traded at its face value (also par value), it is traded at par.

More Background and Terminology: https://www.investopedia.com/terms/b/bond.asp

https://www.investopedia.com/terms/z/zero-couponbond.asp
https://corporatefinanceinstitute.com/resources/accounting/financial-assets/

Test Questions

1. Which of the following statements about bonds is false?

a) A bond is merely a specific form of a loan.

b) Bonds are issued by states and corporations to finance projects and operations.

c) Bonds are financial assets sold by corporations to raise debt capital.

d) There are no zero-coupon bonds.

2. A Japanese zero-coupon bond with a face value of 1000 Japanese Yen will mature in ten years.
What is its present value in Euros, if the appropriate discount rate is 2%, and the EUR/JPY
currency pair is 130?

Background: Know this formula by heart: PV = FV / (1 + R)n, where R is the appropriate discount rate
and n the number of compounding periods.

We want to understand two basic metrics of a bond: Its present value and its yield to maturity. This
question is about present value only. The appropriate discount rate is the annual rate of return of the
best of all equally risky alternative investments. This could be another bond, a savings account, or
stocks. Let's say we could, instead of buying the bond, put money in a Japanese savings account at an
annual interest rate of 2%. The money we deposit today is the present value (PV). After 10 years, we
would have saved PV × (100% + 2%) 10 . Just imagine a pie that grows each year by the factor 1.02, and
undergoes this growth process ten times – hence the exponent. That is the future value (FV): FV = PV ×
(100% + 2%)10. Now we can turn the question around. How much money would we have to deposit in
our Japanese savings account to get exactly 1000 Japanese Yen after ten years? All we have to do is
solve the equation FV = PV × (100% + 2%)10 for PV:

PV = FV / (100% + 2%)10. Plugging in our future value of 1000 Yen gives us:

5
PV = 1000 Yen / (100% + 2%)10 = 1000 Yen / 1.0210 = 820.35 Yen (rounded to the second decimal).

Again, know this formula by heart: PV = FV / (1 + R)n, where R is the appropriate discount rate and n
the number of compounding periods.

Now this calculation shows us that we could get the 1000 Yen in ten years by depositing 820.35 Yen
today. Then certainly we shouldn't pay more for the bond. In this sense, the 820.35 Yen are the bond's
present value. If we bought it for 800 Yen, we would make an economic profit of 20.35 Yen. That profit
is called its net present value. It's just the the difference between the best alternative price and the
actual price of the bond. If we pay more than 820.35 Yen, say 850 Yen, we make an economic loss. The
net present value of this investment would be 850 Yen – 820.35 = –29.65 Yen.

The present value in Euro is now easy to obtain. From the EUR/JPY currency pair of 130 we derive the
unit price of the Yen of 1/130 Euro. So 820.35 Yen are worth 6.31 Euro.

The Analogy between Exchange Rates and Interest Rates

From a comparison of exchange rates and interest rates we can gain a deeper understanding of present
value – the market price of future money in terms of present money. Compare the following
calculations:

Value of $100 at a USD/EUR exchange rate of 1.1: (€1.1 / $1) × $100 = €110

Here, the exchange rate equals the growth factor by which to multiply the stronger currency.

Value of €100 at a USD/EUR exchange rate of 1.1: ($1 / €1.1 ) × €100 = (€100 / 1.1€ ) × $1 = $90.91
(rounded to the second decimal)

Here, the exchange rate determines the discount factor (1 / 1.1) by which to multiply the weaker
currency. An exchange rate higher one means we are considering the unit price of a stronger currency, a
lower one that of a weaker currency (in terms of current purchasing power).

Now consider the meaning of an annual interest rate (or rate of return on investment) of 10%. What
does it mean? It means that for each present currency unit, you pay 100% + 10% = 110% = 1.1 future
currency units in a year. The price reflects our tendency to value present money higher than future
money, and money in the nearer future higher than money in the more distant future.

Let us now choose the dollar as our currency and indicate one present dollar as $ 0. The zero indicates
the distance from the present. Consequently, we denote a dollar one year from now as $ 1, two years as
$2, and so on.

Value of hundred present dollars ($0100) at an annual interest rate of 10%, in terms of future dollars one
year from now ($1) : ($11.1 / $01) × $100 = $1110

Here, the growth factor by which to multiply the present dollars is (100% + 10%) 1, because the
exchange is between present dollars and future dollars in one year. In two years it would be (100% +

6
10%)2, in three years (100% + 10%)3, and so on.

So calculating the future value of a present value is just like calculating the value of a stronger currency
in terms of a weaker currency. And calculating the present value of a future value is just like calculating
the value of a weaker currency in terms of a stronger currency:

Value of hundred future dollars one year from now ($ 1100) , at an annual interest rate of 10%, in terms
of present dollars ($0): $1100 × ($01 / $11.1 ) = ($1100 / 1.1$1 ) × $01 = $090.91 (rounded to the second
decimal). In practice, we simply divide $100 by 1.1.

Obviously, instead of calculating the value of present euros in present dollars, we have calculated the
value of future dollars in terms of present dollars. The math, however, is exactly the same. All we have
to do is to translate the interest rate into an exchange rate of present dollars vs. future dollars and and
reverse this exchange rate, just like we did with the foreign exchange rate.

We can expand the analogy to multiple cash flows: If you have various amounts of money in different
foreign currencies, what is their total value? Of course, you convert each amount into a common
currency and simply add them up. With cash inflows to be received at various points in time, we can do
the exact same. We simply discount each future value and sum up their present values to obtain the
total present value.

3. What is the net present value of a bond with a face value of $1000, when the date of maturity is
two years away and there are two annual coupon payments of 5% outstanding? Assume an
appropriate discount rate of 10% and a price of $800.
Draw a timeline. You know you get the face value of $1000 after two years. But you also get coupon
payments. To calculate the coupon payment, take the face value (also called par value) of $1000.
Multiply by the coupon of 5%: $1000 × 5% = $50. This is the coupon payment in absolute dollar terms.
You get this amount every period (every year in our case) until and including the date of maturity. Now
you know the whole cash flow structure:

Period 0: - $800
Period 1: $50
Period 2: $1000 + $50 = $1050

The total present value of the two future cash flows is (rounded to the second decimal):
PV = $50 : (1 + 10%)1 + $1050 : (1 + 10%)2 = $913.2231405
The net present value (NPV) is simply the present value less the cost of the investment, here the buying
price of $800: NPV = $913.22 - $800 = $113.22

7
4. What is the yield to maturity for a bond that matures after 5 years, has a par value of $1000
and a annual coupon of 10%, if it is acquired at par value? What if it is acquired at a 20%
discount? You can use the calculator at https://irrcalculator.net/. Note that the decimals are
separated by a dot, not by a comma!

Background: The yield to maturity of a bond is its internal rate of return (IRR), an important metric of
investment evaluation, related to but different from present value.

Using https://irrcalculator.net, we take the following steps:

Take the face value or par value of $1000. Multiply by the coupon of 10%: $1000 × 10% = $100. This
is the coupon in absolute dollar terms. You get this amount every period (every year in our case). So the
cash flow in the first period is $100. This repeats itself until the last cash flow in period 5. However, in
the last period, you also get the face value of the bond on top. So in the last period you get not just the
last coupon of $100, but also, and more importantly, the face value of $1000, so a total of $1100.

Period 1: $100
Period 2: $100
Period 3: $100
Period 4: $100
Period 5: $1100

Now all you have to do is type in the initial investment, that is the price at which you buy the bond. If
you buy it at par, you just pay the face value: $1000.
In this case, you can easily see that the issuer borrows those $1000 from you at an interest rate of 10%.
Use the calculator anyways to check that you are using it correctly. Calculated IRR: 10%
If you buy it at a 20% discount, you buy it for $800: $1000 – ($1000 × 20%). Just enter this lower price
as the initial investment and calculate. Calculated IRR: 16.126%. The interest rate is higher now,
because you get the same future cash flow for less present money.

The best term for the IRR is actually discounted cash flow (DCF) rate of return. In the case of a loan or
bond, that's actually just the interest rate of the whole investment – not to be confused with the coupon,
which is independent from the issue or trading price!!

IRR is “internal” or “hidden” only in the sense that it cannot be calculated in as straightforward a
manner as the interest rate or ROI of an investment that generates a single payoff. That's why we have
to use an IRR calculator. The best way to gain an understanding is to play around with the calculator,
using simple intuitive examples like the one above.

8
 2. Stocks

Old Share of Stock

(https://dygtyjqp7pi0m.cloudfront.net/i/37530/32264296_1.jpg?v=8D673533076B670)

Definition: In finance, stock (also capital stock) consists of all the shares by which ownership of
a corporation or company is divided. (Especially in American English, the word "stocks" is also used to
refer to shares.) A single share of the stock means fractional ownership of the corporation in proportion
to the total number of shares. This typically entitles the shareholder (stockholder) to that fraction of the
company's earnings, proceeds from liquidation of assets (after discharge of all senior claims such as
secured and unsecured debt), or voting power, often dividing these up in proportion to the amount of
money each stockholder has invested. Not all stock is necessarily equal, as certain classes of stock may
be issued for example without voting rights, with enhanced voting rights, or with a certain priority to
receive profits or liquidation proceeds before or after other classes of shareholders (Source: wikipedia)

Test Questions

1. According to the shareholder value principle, the purpose of “the corporation” 8 is maximizing
the present value of the cash payoffs it generates. For the shareholders, cash payoffs come in two
forms, resales of their shares and . . .

a) . . . dividends.

b) . . . sales.

c) . . . net income.

d) . . . payments of accounts receivables.

8. That is to say, the desire of its owners, the shareholders.

9
Background: As far as sales, net income and payments of accounts receivables bring cash flow, the
cash flows to the company, not directly to the shareholders.

2. The intrinsic value of a share of stock is . . .

a) . . . the present value of all the cash flows an investor will receive.

b) . . . the future value of all the cash flows an investor will receive.

c) . . . the psychological value of all the benefits an investor will receive.

d) . . . the book value of equity per share

Background: The total present value is ultimately the sum of the present values of all dividends,
according to the dividend discount model.

3. For a corporation that pays out all its earnings in a perpetual stream of equal dividends, what
is its intrinsic value according to the dividend discount model? What is the present value of a
single share?

According to the dividend discount model, the intrinsic value is the total present value of all future
dividends,
N
Dn
PV =∑
n=1 (1+R)n

Dn is the nth dividend and R is the appropriate discount rate, that is the rate of return on investment
(ROI) of the best available and equally risky investment alternative. We're assuming that the dividends
are all the same and that they are paid out forever, which means that this investment is a perpetuity.
∞ C Perp
Recall the general perpetuity shortcut formula: PV Perp =∑ n
= CPerp / R. This means that the
n=1 (1+R)
present value of our company boils down to the simple quotient D Perp/R, where DPerp is the equal amount
of dividends paid out each year forever and R is the appropriate discount rate.

This is the intrinsic value for a mature corporation that doesn't grow anymore and pays out all its
earnings in a perpetual stream of equal dividends.

The value of a single share is simply that intrinsic value divided by the number of outstanding shares.

10
4. Each year, Blackbeard's Taverns Inc. generates a net income of one million dollars, which it
pays out as dividends to its shareholders forever. Assuming an appropriate discount rate of 4%
and a first dividend payment after one year, what is the intrinsic value of Blackbeard's Taverns
Inc.?.
∞ D Perp
Background: The general formula is PV =∑ . DPerp is the same dividend payment in
n=1(1+R)n
perpetuity, in our case it is $1,000,000. There is no finite number of years, so our N is ∞. R is the
∞
$ 1,000,000
appropriate discount rate, in our case 4%. Plugging in our numbers gives us PV =∑ n
,
n=1 (1+0.04)
which boils down to $1,000,000 / 4% = $25,000,000 (see above).

The purely mathematical answer to this question is simple enough. The proof requires some
mathematical creativity. All the more important is it to understand the economics behind the simple
fraction CPerp / R. Both the mathematical and the economic solution lead to the important insight that
even unlimited future cash flows have only limited present value.

The economic explanation for the mathematical result comes from the habit of asking for alternative
ways to purchase the perpetual future cash inflows. We could actually do this by simply lending out
money. Assume the best alternative investment was lending money to the bank at a compound annual
interest rate of 4%. How much would we have to lend so we would be able to receive a $1,000,000
interest payment each year, forever (=in perpetuity)? Note that if we withdraw all of the annual interest,
it actually does not matter whether it is compounded or not, since we withdraw what would be
compounded anyways.

If we lend out $25,000,000, we can claim $1,000,000 interest payment after the first year, and if we
keep on lending the principal, we can again get an interest payment of $1,000,000 after the second, and
so forth. If we never claim back the principal, this goes on ad infinitum. So the present value – that is,
the going market price – of a perpetual stream of interest payments of $1,000,000 is $25,000,000, and
nothing else can be true for Blackbeard's Taverns Inc., since it generates exactly the same cash inflows.

To sum up, how do we arrive at the $25,000,000? If we want to collect an interest payment of
$1,000,000 at the end of the first year (and all the following ones) at an interest rate of 4%, we have to
put down $1,000,000 / 4% = $25,000,000 at the beginning. It does not matter how the perpetual annual
cash flow is generated, whether it is generated by lending money or any other form of investment, such
as stocks.

5. Assume that the two firms A and B are identical in any regard, yet their shares are trading at
different prices, A's at $50 and B's at $125. A has one million shares outstanding and B 200,000.
Measured by market capitalization, which company is cheaper, and by how much?

a) A is cheaper, it costs $75 less.

b) B is cheaper, it has 800,000 fewer shares.

c) A costs less than half of B.

11
d) B costs half as much as A.

Background: Market Capitalization = Price Per Share × Shares Outstanding.9

The price at which shares of a publicly-listed company are traded keeps changing with each trade and
passing second, so the market capitalization (jargon: market cap) fluctuates accordingly. The number of
outstanding shares can also change, for example through new stock issues or buybacks.
Firm A trades at $50 per share and has one million outstanding shares, so its market capitalization is
($50 x 1 million shares) = $50 million.
Firm B trades at $125 per share but has only 200,000 outstanding shares, so its market capitalization is
($125 x 200,000 shares) = $25 million.
Hence despite the lower price per share outstanding, firm A has actually double the market
capitalization of B, and however large a relative share of it we want to purchase, it costs us double the
money.

As always, visualization is the key to understanding. Imagine company A as a pie sliced into eight
pieces – outstanding shares – at $2.25 each and company B as another pie sliced into just two pieces at
$5 each. To buy half of company B costs $5, to buy half of company A we need to buy four pieces at a
total of $10.

The simple takeaway is that we cannot directly compare the prices of two shares of stock, we first have
to take into account the relative size of the shares, which depends on the number of shares outstanding.
In a next step, we would also have to take account of the absolute size of the pies, of course.

Market Capitalization in Margin Call (2011) - Peter Sullivan discovers the firm's projected losses on
MBS products [HD 1080p] - YouTube

6. Consider the stock quotation at https://www.investopedia.com/articles/investing/093014/stock-

quotes-explained.asp. What is the meaning of the various items in the table? How many shares
were exchanged? (For the meaning of “bid” and “ask”, see the related question below).

Background: The number of shares exchanged in the last trade is actually not given, nor do we learn in
this quotation about any other quantity of shares demanded, supplied or exchanged, for example in the
opening trade. However, all prices and price offers refer to definite quantities of shares. The last trade
will have transferred a definite number of shares; in fact, it could just have been exactly one share.

For the concrete answers, read the article. More detailed and better even is
https://www.thebalance.com/trading-definitions-of-bid-ask-and-last-market-prices-1031026

For a deeper understanding, note the following:

9. Even engineers and other mathematically educated professionals can struggle with simple arithmetic when exposed to the
unfamiliar waters of finance and not giving it much thought, as Salman Khan reports at
https://www.khanacademy.org/economics-finance-domain/core-finance/stock-and-bonds/valuation-and-investing/v/price-
and-market-capitalization?modal=1

12
Strictly speaking, there is no such thing as “the” price of a good in terms of another. There are as many
prices (=exchange rates) as there are trades (=exchanges). That there is a tendency for prices to
converge to a particular value or even that a number of trades is carried out at the same exchange rate
doesn't change this fact. That two people have the same or very similar body weight doesn't change the
fact that each has their own body and body weight.

“The” price of the stock that day is simply – by convention – the closing price of that day, that is, the
exchange rate at which the last trade was executed before the market officially closed for normal
trading. It is usually different from the opening price, and between the opening and the closing of the
market, prices can and will vary.

The notion of “the” price as something inherent in a good – be it coconuts or shares of stock – has for a
long time stood in the way of a proper understanding of price formation. 10 In the real world, exchanges
refer to definite quantities exchanged at a definite point in time, between definite parties with definite
perceptions, anticipations and evaluations. On those subjective factors depend the maximum buying
prices and minimum selling prices of the actors involved in a trade. That those subjective beliefs are
about objective facts – be it the nutritional value of a coconut or the intrinsic value of a company –
doesn't change the fact that prices reflect those subjective beliefs first, and only indirectly the
underlying facts.

Now we understand why market capitalization reflects the intrinsic value of a corporation, if and
insofar market participants are well-informed and behave rationally. The reason is that it reflects the
perceptions and anticipations of shareholders and potential buyers about the present value of the future
cash flows the corporation will generate.

7. Consider again the stock quotation at

https://www.investopedia.com/articles/investing/093014/stock-quotes-explained.asp. What do
“bid” and “ask” mean?

a) The highest offer to buy and the lowest offer to sell.

b) The highest offered maximum buying price and the lowest offered minimum selling price.

c) The best limit orders.

d) All of the above.

Background: The order book is a list of limit buy and sell orders for a specific security or financial
instrument as a function of price. It is visualized in an order book depth chart, which corresponds to the
sellers above and the buyers below the equilibrium price in a supply and demand graph. Learn more at
https://vantagepointtrading.com/bid-ask-and-last-price-understanding-stock-quotes/

10. The first ones to see through this fallacy were the Spanish Scholastics: “According to thinkers in the School of
Salamanca, economic value no longer resides within the object. Instead, value comes from the people participating in the
market and can, therefore, vary by time and place (and ultimately personal preference) without any physical or material
change to the good itself.” More on the history of economic and legal price theory at
https://www.econlib.org/library/Columns/y2020/Muellerjustprice.html

13
8. Consider the order book depth chart at https://en.wikipedia.org/wiki/Order_book. According
to the law of supply and the law of demand,

a) the left side must represent the buyers.

b) the right side must represent the sellers.

c) a) and b)

d) None of the above, the laws of supply and of demand are merely theories.

Background: We have refreshed our understanding of the laws of supply and of demand with our
experiments, here we see how equilibrium price theory applies to the real world financial market
processes and price formation. You find a good illustration of the market process at
https://wp.fxssi.com/wp-content/uploads/2019/04/ru_post-images.jpg and https://wp.fxssi.com/wp-
content/uploads/2019/04/en_orderbook-explain-2.jpg. (link broken)

14
 3. The Role of Time, Spot and Futures Markets

For producers, what counts are not the spot prices when they start producing, but the spot prices when
their product is ready to be sold. Financial markets serve this need through forward and futures
contracts.

To gain a more quantitative understanding of a forward contract, compare it to the choice between a
safe bet and a risky one, and their respective expected values. Watch How To Calculate Expected Value
- YouTube at https://www.youtube.com/watch?v=b6VK2VPMXNI for example calculations.

To gain a principled understanding of the futures market, watch the Midwest Grain Trade: History of
Futures Exchanges - YouTube at https://www.youtube.com/watch?v=GUYAoueXqK and What Do
Prices "Know" That You Don't? - YouTube at https://www.youtube.com/watch?v=WPy-QKXofQs

Cash settlement example taken from Cash Settlement: Definition, Benefits and Examples
(investopedia.com):

Futures contracts are taken out by investors who believe a commodity will increase or
decrease in price in the future. If an investor goes short a futures contract for wheat, they
are assuming the price of wheat will decrease in the short term. A contract is initiated with
another investor who takes the other side of the coin, believing wheat will increase in price.

An investor goes short on a futures contract for 100 bushels of wheat for a total of $10,000.
This means at the end of the contract, if the price of 100 bushels of wheat drops to $8,000,
the investor is set to earn $2,000.

However, if the price of 100 bushels of wheat increases to $12,000, the investor loses
$2,000. Conceptually, at the end of the contract, the 100 bushels of wheat are "delivered" to
the investor with the long position.

To make things easier, a cash settlement can be used. If the price increases to $12,000, the
short investor is required to pay the difference of $12,000 - $10,000, or $2,000, rather than
actually delivering the wheat. Conversely, if the price decreases to $8,000, the investor is
paid $2,000 by the long position holder.

15
 C. Finance in German and European History

From "The Vampire Economy: Doing Business under Fascism": The Vampire Economy (mises.org) at
https://cdn.mises.org/the_vampire_economy_20201022.pdf, page 68, "Price Dictatorship and Private
Initiative"

How cunning ingenuity and "private initiative" circumvent official rules in a country under
totalitarian rule can be illustrated by the way in which a dealer bought a pig from a peasant in Nazi
Germany. A peasant was arrested and put on trial for having repeatedly sold his old dog together
with a pig. When a private buyer of pigs came to him, a sale was staged according to the official
rules. The buyer would ask the peasant: "How much is the pig?" The cunning peasant would
answer: "I cannot ask you for more than the official price. But how much will you pay for my dog
which I also want to sell?" Then the peasant and the buyer of the pig would no longer discuss the
price of the pig, but only the price of the dog. They would come to an understanding about the price
of the dog, and when an agreement was reached, the buyer got the pig too. The price for the pig was
quite correct, strictly according to the rules, but the buyer had paid a high price for the dog.
Afterward, the buyer, wanting to get rid of the useless dog, released him, and he ran back to his old
master for whom he was indeed a treasure.

"Destruction of the Sanctity of Private Property", ibid. page 10:

Herr V. is one of the largest landowners in Eastern Prussia. He is a conservative old landowner who
was
once proud of being the free and independent master of a huge domain and who boasted of his
patriarchal relations with his employees. As an ardent German nationalist he felt certain, when
Hitler came to power,that the country had been "saved from the Bolshevists and the Jews." He never
dreamed that the new regime would dare interfere with his God-given rights far more than had the
Social-Democratic government he had hated. Unable to grasp quickly enough the changes that were
occurring, he did not conform to the ever-mounting requirements of the ruling Party. Soon he was
on bad terms with the provincial Party secretary, whom he despised as an upstart. The Party leader
tried to break his stubborn spirit by all manner of petty decrees and regulations, as, for instance, by
ordering him to give lodging to S.A. men (Brownshirts) and members of the Hitler Youth League,
who annoyed him endlessly. There was no longer a Hindenburg, who as President of the Reich and
Supreme Commander of the Army, would listen to the complaints of his agrarian friends and
intervene with the government on their behalf.

Herr V. learned only through bitter experience that there was no longer any court or official to
protect him, and he began to fear that his estates might be expropriated. He visited his former
banker, Herr Z., to whom he confessed: “I want to invest my liquid funds in a way which is safe,
where they can't be touched by the State or the Party. In the old days I always refused to speculate,
to buy stocks. Now I would not mind. However, I would like best to buy a farm in South-West
Africa. Perhaps my next crop will be a failure and I will be blamed, accused of "sabotage," and
replaced in the management of my estates by a Party administrator. I want to be prepared for such a
contingency and have a place to go should the Party decide to take away my property.” The banker
was compelled to inform his landowner friend that there was no such way out. The State would not
allow him to leave Germany with more than ten marks. South-West Africa was closed to him; he
would have to stay where he was.

16
Currency and market reforms in post-WW2 Germany:

BREXIT THE MOVIE - THE GERMAN MIRACLE ... A LESSON FROM HISTORY (9 of 26) -
YouTube at https://www.youtube.com/watch?v=AHQ_7vx6xx0

Wikipedia Fact Check (Version 22/02/23):

The Marshall Plan aid was divided among the participant states roughly on a per capita
basis. A larger amount was given to the major industrial powers, as the prevailing opinion
was that their resuscitation was essential for the general European revival. Somewhat more
aid per capita was also directed toward the Allied nations, with less for those that had been
part of the Axis or remained neutral. The largest recipient of Marshall Plan money was
the United Kingdom (receiving about 26% of the total). The next highest contributions
went to France (18%) and West Germany (11%). Some eighteen European countries
received Plan benefits.[4]

Ludwig Erhard and the German Economic Miracle - YouTube at https://www.youtube.com/watch?

v=a0D1RAY5NZ8&t=1s

Playmobil's German inventor Hans Beck dies aged 79 | World news | The Guardian at
https://www.theguardian.com/world/2009/feb/03/playmobil-inventor-hans-beck-dies

"The trigger for the toy's creation was the global oil crisis of the early 1970s, when the
price of plastics increased sixfold. Large toys which Brandstätter had produced up until
then became prohibitively expensive and it was forced to rethink its product line.

Beck was asked to develop a "system of play which can be expanded and which through
relatively small parts made out of the expensive synthetic material offers a high value
product"

Risk literacy: Gerd Gigerenzer at TEDxZurich - YouTube on "behavioral economics" at 10:55

17