GLOBAL ECONOMIC ENVIRONMENT

SESSION 8

Prof. Manuel Trenado

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Program Outline
• Part 1 (4 Sessions)
– Introduction. Business Cycles
• Part 2 (3 Sessions)
– Fiscal Policy and the Role of Government
– Sovereign debt and default
• Part 3 (3 Sessions)
– Financial Markets
• Part 4 (6 Sessions)
– The Banking Sector
– Global Financial Crisis
• Part 5 (6 Sessions)
– Exchange rates and balance of payments
22 Sessions (+) 2 Midterms (+) 4 Sessions Final Presentations
(+) 2 Review Sessions= 30 Sessions
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Key Concepts

• Equities

• Global Markets & Financial Assets

• Determination of Stock Prices

• Risk and Speculation

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Financial Markets
• Main constituents
– Banks
– Equity and bond markets
• Key role as meeting point of savers and
individuals/corporations in need of financing
• Support economic activity
– Provides financing to corporations for
investment
– Provides financing to individuals for
consumption
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Global Financial Assets
Financial assets made of Bank Deposits, Debt Securities
(government and private) and Equities

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 Sectorial Flow of Funds
Generally speaking, households are net lenders to the
government and corporations
3
2.5 assets liabilities
% of GDP

2
1.5
1
0.5
0
non financial financial government Households Overseas
corporations corporations
Australian Financial Assets and Liabilities by Sector (2008)

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 Financial Development
• Evidence suggest that a developed financial sector is
an important driver of economic growth
• Functioning banking sector and efficient markets are
essential to foster economic growth

per capita GDP 4%

growth 1976-98
3%

2%

1% Liquid
0% Stock Market
Illiquid
High Liquidity, 1976
Banking Development, 1976 Low

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Financial Markets: Debt vs. Equity
(1/2) Key Differences

Two major sources of financing for corporations

Debt Equity
Not an ownership interest Ownership
No Voting Rights Voting Rights
Dividends paid after corporation
Interest payments tax exempt
tax
Creditor have legal recourse if Share holders have no legal
payments not made recourse if dividends not paid
An all-equity financed firm
Excess debt can lead to bankruptcy
cannot go bankrupt

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 Financial Markets: Debt vs. Equity
(2/2) Stock Market Capitalisation
Stock market is a more often source of financing in US than EU
250%

200%
% of GDP

150%

100%

50%

0%

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Equity Markets

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Equity Markets
• Companies issue shares to the market
(primary market)
• These shares are subsequently exchanged
among investors (secondary market)
• A share gives the owner a participation in
the company
– A share of profits (dividends)
– Possibility of gains from stock price appreciation
(capital gains)

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Sources of Equity Investor Return

P(1) - P(0) D(1)

+ =r
P(0) P(0)

Dividend Yield
Expected Capital Gains

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 Return on Investment: the Long View
Over long run, return on equities has exceeded the return on
nearly every other asset
1000000
Stocks $104,091
100000

10000

Bonds $550
Dollars

1000

100 Bills $346

Gold $59
10 CPI $17

0.1
1871 1881 1891 1901 1911 1921 1931 1941 1951 1961 1971 1981 1991 2001

Value of investing $1 in 1871

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Stock Market Indices
Not just on emerging economies…

51200
25600
12800
6400
3200
1600
800 UK
400 US
200
100
50
25
1753
1765
1777
1789
1801
1813
1825
1837
1849
1861
1873
1885
1897
1909
1921
1933
1945
1957
1969
1981
1993
2005
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Determination of Stock Prices
• Intrinsic or fundamental value of stocks
equals the present value of future expected
dividends
– Price should reflect underlying profitability of
company
– Dividends are directly driven by this underlying
profitability and by the dividend policy
• Market value may differ from intrinsic value
– Asymmetry of information, speculation, etc

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Unpredictability
• Note importance of expected future
dividends
– Expectation on future profitability
– Expectation on dividend policy
• How are expectations formed?
– Rational?
– Efficient?

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Bubbles – Tulip Mania

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Reddit & Gamestop
• https://youtu.be/YFQ-v1jCpF0

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The Mechanics of Short Selling
• t=0 I borrow 2 baseball cards from a friend
(no cash, just sign contract)
• t=0 (immediately thereafter) I sell them at $ 400 (market value)
(+ $400 cash inflow)
CASE 1 (price drops)
I have to buy the cards in the market as I BORROWED them, I have to give
back the 2 cards to my friend
• t=n market value of the two baseball cards is $300
(- $300 cash outflow)
• Total +$400 (t=0) - $300 (t=n) = $100 profit (minus interest paid to lender)
CASE 2 (price increases) (the clincher)
• t=n market value of the two baseball cards is $500
(- $500 cash outflow)
• Total +$400 (t=0) - $500 (t=n) = $100 loss (plus interest paid to lender)

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Short Squeeze
• A short selling strategy necessarily involves a moment in
the future where the shortseller has to buy the stock in
order to give it back to the lender
– as promised – as they borrowed the stock, not bought it
• As a result, if many short sellers buy the stock at the same
time, the stock price may increase rapidly
– destroying this way their profits (as they benefit when the share
price falls, not increases)
• This is what a short squeeze is

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