Financial issues

Typical Costs When Trading Financial Goods – Stocks

admin — Sun, 01 Nov 2009 20:47:50 +0000

Similarly, ﬁnancial markets transactions also incur transaction costs. If an investor wants to buy or sell shares of a stock, the broker charges a fee, as does the stock exchange that facilitates the transaction. In addition, investors have to consider their time to communicate with the broker to initiate the purchase or sale of a stock as an (opportunity) cost.
Brokerage and Market-Maker Commissions, direct costs: Still, the transaction costs for selling . ﬁnancial instruments are much lower than they are for most other goods. Let’s look at a few reasons why. First, even if you want to buy (or sell) $1 million worth of stock, some Internet brokers now charge as little as $10 per transaction. Your round-trip transaction, which is a buy and a sale, costs only $20 in broker’s commission. In addition, you have to pay the spread (the diﬀerence between the bid and the ask price) to the stock exchange. For example, a large company stock like PepsiCo (ticker symbol PEP) may have a publicly posted price of $50 per share. But you can neither buy nor sell at $50. Instead, the $50 is really just the average of two prices: the bid price of $49.92, at which another investor or the exchange’s market-maker is currently willing to buy shares; and the ask price of $50.08, at which another investor or the exchange’s market-maker is currently willing to sell shares. Therefore, you can (probably) purchase shares at $50.08 and sell them at $49.92, a loss of “only” 16 cents which amounts to round-trip transaction costs of ($49.92 − $50.08)/$50.08 ≈ −0.32%. You can compute the total costs of buying and selling 20,000 shares ($1,000,000 worth) of PepsiCo stock as This is not exactly correct, though, because the bid and ask prices that the exchange posts (e.g., on Yahoo!Finance or the Wall Street Journal ) are only valid for 100 shares. Moreover, some transactions can occur inside the bid-ask spread, but for most large round-trip orders, chances are that you may have to pay more than $50.08 or receive less than $49.92. So 0.32% is probably a bit too small. (In fact, if your trade is large enough, you may even move the publicly posted exchange price away from $50!) Your buy order may have to pay $50.20, and your sell may only get you $49.85. In real life, the true round-trip transaction cost on a $1 million position in PEP is on the order of magnitude of 50 basis points.
The above applies primarily to a market order, in which you ask your broker to buy or sell at the prevailing market price. A limit order can specify that you only wish to buy or sell at $50.00, but you are patient and willing to take the chance that your order may not get executed at all. There is a common belief that limit orders are “cheaper” in terms of transaction costs, but also “riskier.” For example, if you have a standing limit order to buy at $50, and the company reveals that it has managed earnings, so its value drops from $51 to $20, your limit order could still easily execute at $50.
Indirect and Opportunity Costs: Investors do not need to spend a lot of time to ﬁnd out the latest price of the stock: it is instantly available from many sources (e.g., from the Internet such as Yahoo!Finance). So, the information research costs are very low: unlike a house, the value of a stock is immediately known. Finally, upon demand, a buyer can be found practically instantaneously, so search and waiting costs are also very low. Recall the often multi-month waiting periods if you want to sell your house.
Compare the ﬁnancial securities transaction costs to the transaction costs in selling a house.Broker fees alone are typically 6%: for the $100,000 equity investment in the $500,000 house, this comes to $30,000 for a round-trip transaction. Add the other fees and waiting time to this cost and you are in for other transaction costs, say, another $10,000. And houses are just one example: Many transactions of physical goods or labor services (but not all) can incur similarly high transaction costs.
In contrast, if you want to buy or sell 100 shares in, say, Microsoft stocks, your transaction costs are relatively tiny. Because there are many buyers and many sellers, ﬁnancial transaction costs are comparably tiny. Even for a $100,000 equity investment in a medium-sized ﬁrm’s stock, the transaction costs are typically only about $300–$500. To oversimplify, this blog will make the incorrect, but convenient assumption that ﬁnancial transaction costs are zero (unless otherwise described). For individuals buying and selling ordinary stocks only rarely (a buy-and-hold investor), a zero transaction cost assumption is often quite reasonable. But if you are a day trader—someone who buys and sells stocks daily—you better read another blog!

Inﬂation

admin — Mon, 05 Oct 2009 20:43:46 +0000

We have now discussed all violations from the assumptions necessary for our perfect market Utopia. So, what are we doing now? If you return to our perfect markets assumptions, you will see that “no inﬂation” was not among them. Inﬂation is the process by which goods cost more in the future than they cost today—in which the price level is rising and money is losing its value.
So, inﬂation is actually not a market imperfection per se. If today we quoted everything in dollars, and tomorrow we quote everything in cents—so that an apple that cost 1 currency unit today will cost 100 currency units tomorrow, an inﬂation of 10,000%—would it make any difference? Not really. The apple would still cost the same in terms of foregone other opportunities, whether it is 1 dollar or 100 cents.
However, we have made a big assumption here—inﬂation applied equally to everything, and especially applied equally to all contracts across time. See, if you had contracted to deliver apples at 1 currency unit tomorrow, whatever currency units may be, you could be in big trouble—you would have promised to sell your apples at 1 cent (1 currency unit) instead of $1. Most ﬁnancial contracts are denominated in such “nominal” terms—that is, in plain currency units—so inﬂation would matter. Of course, inﬂation would not be much of a concern for a ﬁnancial contract that would be “inﬂation-indexed.”
What effect does inﬂation have on returns? On (net) present values? This is the subject of this post. As before, we start with interest rates and then proceed to net present values.

Tax Timing

admin — Tue, 29 Sep 2009 20:42:31 +0000

In many situations, the IRS does not allow reinvestment of funds generated by a project without an interim tax penalty. This can be important when you compare one long-term investment to multiple short-term investments that are otherwise identical. For example, consider a farmer in the 40% tax bracket who purchases grain that costs $300, and that triples its value every year.
• If the IRS considers this farm to be one long-term two-year project, the farmer can use the ﬁrst harvest to reseed, so $300 seed turns into $900 in one year and then into a $2,700 harvest in two years. Uncle Sam considers the proﬁt to be $2,400 and so collects taxes of $960. The farmer is left with post-tax proﬁts of $1,440.
• If the IRS considers this production to be two consecutive one-year projects, then the farmer ends up with $900 at the end of the ﬁrst year. Uncle Sam collects 40% ·$600 = $240, leaving the farmer with $660. Replanted, the $660 grows to $1,980, of which the IRS collects another 40% ·$1, 980 = $792. The farmer is left with post-tax proﬁts of 60% ·$1, 980 = $1, 188.
The discrepancy between $1,440 and $1,188 is due to the fact that the long-term project can avoid the interim taxation. Similar issues arise whenever an expense can be reclassiﬁed from “reinvested proﬁts” (taxed, if not with some credit at reinvestment time) into “necessary maintenance.”
Although you should always get taxes right—and really know the details of the tax situation that applies to you—be aware that you must particularly pay attention to getting taxes right if you are planning to undertake real estate transactions. These have special tax exemptions and tax depreciation writeoffs that are essential to getting the project valuation right.

Reﬂections On The Example and Debt and Equity Risk

admin — Sat, 19 Sep 2009 20:38:31 +0000

We have not covered risk yet, because we did not need to. In a risk-neutral world, all that matters is the expected rate of return, not how uncertain you are about what you will receive. Of course, we can assess risk even in a risk-neutral world, even if risk were to earn no extra compensation (a risk premium).
So, which investment is most risky: full ownership, loan ownership, or levered ownership? As the visual shows, the loan is least risky, followed by the full ownership, followed by the levered ownership. Your intuition should tell you that, by taking the mortgage, the medium-risky project “building” has been split into a more risky project “levered building” and a less risky project “mortgage.” The combined “full building ownership” project therefore has an average risk.
It should not come as a surprise to learn that all investment projects expect to earn a 10%rate of return. After all, 10% is the time-premium for investing money. Recall from the previous posts that the expected rate of return (the cost of capital) consists only of a time-premium and a risk premium. (The default premium is a component only of promised interest rates, not of expected interest rates). By assuming that investors are risk-neutral, we have assumed that the risk premium is zero. Investors are willing to take any investment that offers an expected rate of return of 10%, regardless of risk.
Although our example has been a little sterile, because we assumed away risk preferences, it is nevertheless very useful. Almost all projects in the real world are ﬁnanced with loans extended by one party and levered ownership held by another party. Understanding debt and equity is as important to corporations as it is to building owners. After all, stocks in corporations are basically levered ownership claims that provide money only after the corporation has paid back its loans. The building example has given you the skills to compute state-contingent, promised, and expected payoffs, and state-contingent, promised, and expected rates of returns—the necessary tools to work with debt, equity, or any other state-contingent claim. And really, all that will happen later when we introduce risk aversion is that we will add a couple of extra basis points of required compensation—more to equity (the riskiest claim) than to the project (the medium-risk claim) than to debt (the safest claim).

The Loan

admin — Sat, 12 Sep 2009 20:36:54 +0000

We now assume you want to ﬁnance the building purchase of $76,363.64 with a mortgage of $25,000. In effect, the single project “building” is being turned into two different projects, each of which can be owned by a different party. The ﬁrst project is the project “Mortgage Lending.” The second project is the project “Residual Building Ownership,” i.e., ownership of the building but bundled with the obligation to repay the mortgage. This “Residual Building Ownership” investor will not receive a dime until after the debt has been satisﬁed. Such residual ownership is called the levered equity, or just the equity, or even the stock in the building, in order to avoid calling it “what’s-left-over-after-the-loans-have-been-paid-off.”
What sort of interest rate would the creditor demand? To answer this question, we need to know what will happen if the building were to be condemned, because the mortgage value ($25,000 today) will be larger than the value of the building if the tornado strikes ($20,000 next year). We are assuming that the owner could walk away from it and the creditor could repossess the building, but not any of the borrower’s other assets. Such a mortgage loan is called a no-recourse loan. There is no recourse other than taking possession of the asset itself. This arrangement is called limited liability. The building owner cannot lose more than the money that he originally puts in. Limited liability is a mainstay of many ﬁnancial securities: for example, if you purchase stock in a company in the stock market, you cannot be held liable for more than your investment, regardless of how badly the company performs.

Typical Costs When Trading Real Goods—Houses

admin — Thu, 10 Sep 2009 20:47:16 +0000

When you engage in transactions, i.e., a purchase or sale, you face costs to facilitate the transactions. Real estate is a perfect example to illustrate transaction costs. The personal residence is the most signiﬁcant asset that most people own, real estate is a very large part of the total value of the economy, and real estate transaction costs are so high that they will register with anyone who has ever had to sell a house. The real estate example also will allow you to contrast the real-estate transaction costs later with ﬁnancial securities transaction costs. So, what does selling or buying a house really cost?
Brokerage Commissions, a direct cost: In the United States, if a house is sold, the seller’s broker typically receives six percent of the value of the house as commission (and splits this commission with the buyer’s agent). Thus, if a real estate agent manages to sell a house for $300,000, the commission is $18,000. Put differently, without an agent, the buyer and seller could have split the $18,000 between them. (Of course, brokers do many useful things, such as matching buyers and sellers, shepherding the selling process, etc., so the $18,000 may just be the intrinsic transaction cost to selling a house. However, inconsistent with this view, real estate commissions are much lower in other countries, and it is difficult to see why the cost of selling houses would be exactly 6% in practically all markets in the United States.)
Although only the seller pays the broker’s cost, it makes sense to think of transaction costs in terms of round-trip costs—how much worse you are off if you buy and then immediately sell an asset. You would mislead yourself if you thought that when you buy a house, you have not incurred any transaction costs because the seller had to pay them—you have incurred an implicit transaction cost in the future when you need to resell your investment. Of course, you usually do not immediately sell assets, so you should not forget about the timing of your future selling transaction costs in your NPV calculations.
Housing transaction costs are so high and so important that they are worth a digression. If you borrow to ﬁnance the investment, transaction may be higher than you think. The real estate agent earns 6% of the value of the house, not of the amount of money you put into the house. On a house purchase of $500,000, the typical loan is 80% of the purchase price, or $400,000, leaving you to put in $100,000 in equity. Selling the house the day after the purchase reduces the owner’s wealth of $100,000 by the commission of $30,000—for an investment rate of return of –30%. This is not a risk component; it is a pure and certain transaction cost.
Let us brieﬂy consider what happens if the house price decreases or increases by 10%. If house prices decline by 10%, or the buyer overpays by 10%, the house can only be resold for $450,000, which leaves $423,000 after agent commissions. The house owner is left with $23,000 on a $100,000 investment. A 10% decline in real estate values has reduced the home owner’s net worth by 77%! In comparison, a 10% increase in real estate values increases the value of the house to $550,000, which means that $517,000 is left after real estate commissions. The house owner’s rate of return for the same up movement is thus only 17%.
With the tools you already know, you can even estimate how the value of a typical house might change if the Internet could instantly and perfectly replace real estate agents. You cannot be too accurate—you can only obtain a back-of-the-envelope estimate. A typical house in the United States sells every seven years or so. Work with a $1,000,000 house, and assume that the expected house capital-gain appreciation is 0%—you consume all gains as rental enjoyment. In this case, the house will stay at $1,000,000 in value, the commission will stay constant at$60,000 and will be paid every 7 years. If the appropriate 7-year interest rate were 40% (around 5% per annum), then the value of the brokerage fees would be a perpetuity of $60, 000/40% = $150, 000. The capitalized transaction cost would therefore have lowered the value of the $1,000,000 house by $150,000. If you could eliminate all commissions, e.g., by selling equally efficiently over the Internet, such a house would increase in value by about 15%. However, if you believed that the brokerage commission were to go up by the inﬂation rate (2% per annum, or 15% per 7-years), the friction would not be $150,000 but $240,000—more like 25% of the value of the house, not just 15%.
Other direct costs: In addition to direct agent commissions, there are also many other direct transaction costs. These can range from advertising, to insurance company payments, to house inspectors, to the local land registry, to postage—all of which cost the parties money. Indirect and opportunity costs: Then there is the seller’s own time required to learn as much . about the value of the house as possible, and the effort involved to help the agent sell the house. These may be signiﬁcant costs, even if they involve no cash outlay. After all, the seller could spend this time working or playing instead. Furthermore, not every house is suitable for every house buyer, and the seller has to ﬁnd the right buyer. If the house cannot be sold immediately but stays empty for a while, the foregone rent is part of the transaction cost. The implicit cost of not having the house be put to its best alternative use is called an opportunity cost. Opportunity costs are just as real as direct cash costs.

Splitting Project Payoﬀs into Debt and Equity

admin — Sat, 05 Sep 2009 20:35:50 +0000

We now know how to compute the NPV of state-contingent payoffs—our building paid off differently in the two states of nature. Thus, our building was a state-contingent claim—its payoff depended on the outcome. But it is just one of many. Another state-contingent claim might promise to pay $1 if the sun shines and $25 if a tornado strikes. Using payoff tables, we can work out the value of any state-contingent claims—and in particular the value of the two most important state-contingent claims, debt and equity.

Present Value With State-Contingent Payoﬀ Tables

admin — Thu, 27 Aug 2009 20:34:17 +0000

Almost all companies and projects are ﬁnanced with both debt and levered equity. We already know what debt is. Levered equity is simply what accrues to the business owner after the debt is paid off. You already have an intuitive sense about this. If you own a house with a mortgage, you really own the house only after you have made all debt payments. If you have student loans, you yourself are the levered owner of your future income stream. That is, you get to consume “your” residual income only after your liabilities (including your non-ﬁnancial debt) are paid back. But what will the levered owner and the lender get if the company’s projects fail, if the house collapses, or if your career takes a turn towards Rikers Island? What is the appropriate compensation for the lender and the levered owner? The split of net present value streams into loans (debt) and levered equity lies at the heart of ﬁnance. We will illustrate this split through the hypothetical purchase of a building for which the future value is uncertain. This building is peculiar, though: it has a 20% chance that it will be destroyed, say by a tornado, by next year. In this case, its value will only be the land—say, $20,000. Otherwise, with 80% probability, the building will be worth $100,000. Naturally, the $100,000 market value next year would itself be the result of many factors—it could include any products that have been produced inside the building, real-estate value appreciation, as well as a capitalized value that takes into account that a tornado might strike in subsequent years.