All Terrain Thinking

A Compendium of things I think are Important

Economics: It's not just whats' in your wallet

S&D in Action: Exchange Rates and Investing

Exchange rates

A History of the value of the $

The ground rules

• the price of the dollar, what some would refer to as the value of dollar or the exchange rate, is the number of units of a foreign currency needed to buy a dollar (ex. 97 yen per dollar).
• people want to be paid in their domestic currency.  German workers want to be paid in German marks while the US government will want US dollars when it sells Treasury securities to English investors.
• the exchange rate is set in the international money market, something very much akin to the US stock market.  In that market there are buyers and sellers of currencies and the exchange rate is determined by the interaction of the buyers and sellers.  People will need to come to the international money market when they are involved in an international transaction.
• demand for dollars is generated every time someone anywhere in the world wants to buy US goods and services or US assets. The export of US rice to Japan in 1997 or the purchase of US government 'mortgages' by investors in Germany are examples of transactions that would generate a demand for dollars.  Both the US government and the farmers producing the rice would like to be paid in dollars so foreign buyers will go to the international money market with their domestic currency and demand (buy) dollars to pay their bills for the rice and mortgages.
• supply of dollars is generated every time someone in the US tries to buy goods and services and assets from abroad.  When Americans buy French wine or travel to Tokyo for business they will pay for the wine in French francs and the hotel room in Japanese yen.  In both cases they will need to go to the international money market where they will supply US dollars to the money market to exchange them for the francs and yen needed to make their purchases. 

Exchange Rate

Prices at exchange rate of 5f per $

Prices at exchange rate of 2f per $

Potential explanations for the decline of the US dollar.

• Deterioration in the balance of trade deficit: to pay for the increase in imports that produces the trade deficit, Americans must sell dollars to buy the foreign currency necessary to pay for their imports. [supply curve shifts out]
• Rapid growth outside of the US: US investors, seeking the highest rate of return on their money, are increasing their supply of dollars to purchase foreign currency which they need to finance their purchase of stock on foreign stock exchanges. [supply curve shifts out]
• Low interest rates in the US: foreign investors, seeking the highest rate of return on their money, are selling US government securities and buying foreign securities that generates an increase in the supply of US dollars. [supply curve shifts out]
• Kobe earthquake: demand for dollars by Japanese investors to buy US assets will decline as some of the investors decide to use their funds to help rebuild Kobe rather than buy US government securities [demand curve shifts in].
• Loss in 'confidence' in the dollar: demand for dollars in the post W.W.II era remained high as foreign investors and central bankers preferred to hold their cash as dollars, but the rise of new economic super powers Japan and Germany has prompted both investors and central bankers to diversify their cash portfolio by selling their dollars to buy Japanese yen and German marks. [demand curve shifts in].

Investing for the 21st century

Why

The "Record"

Chris's Income Statement

Chris's Balance Sheet

What

• Human Capital (people)
• Real Estate and Gold
• Stocks
• Bonds

Stocks

• What are stocks?
• Why would you own them?
• How do you make money owning stock?
• Where are the stocks bought and sold?
• How do you read stock market information?  
• What are the stock market indexes?
• How do you account for inflation?
• What are mutual funds?
• How do you follow the stock markets?

How do you read stock market information?

Individual company information

• 52 Weeks Hi: the highest price for the stock in the past year
• Lo: the lowest price for the stock in the last year
• Stock: the abbreviated name of the issuing company: AT&T is the company issuing the stock.
• Sym: the symbol for the stock - what you would enter into the various on-line quote sites
• Div: the expected dividend.  The owner of this stock can expect to earn $1.32 in dividends for each share owned.
• Yield: the expected dividend as a percentage of the current price.  The owner will receive $1.32 for the stock which costs $58.75 which is a rate of return of 2.2 percent. 
• PE: The ratio of the price of the stock to the expected earnings per share.  The price per share is twenty times the expected earnings per share.  This is sometimes used as a measure of the extent to which the stock is over or under priced.  A high price - earnings ratio means that the investor is paying a high price for the expected profit that the company will make.
• Vol: the number of shares traded in 10s.  On this day 3,667,700 shares were traded.
• Hi: the highest price for the stock that day
• Lo: the lowest price for the stock that day
• Net Chg: the change in the price of the stock between yesterday's and today's closing.

What are the stock market indexes?

New York Stock Exchange

Dow Jones average DJA web site.   

• Industrials (Coca-Cola, Eastman Kodak, McDonald's, Boeing, General Motors, and Merck)
• Transportation (AMR (American Airlines), Southwest Air, Union Pacific, and Delta)
• Utilities (American Electric Power Co. and Enron).  The most popular of the Indexes is the Industrial which is usually the index quoted on the nightly news.   In these indexes the weight for each stock price is one so that what we have is a simple, un-weighted average. 

New York Composite gives the average price for all of the stock is traded on the New York Stock Exchange where the weight for each stock price is the number of shares of the stock. This is more like a price index.

Standard & Poors 500    

• "The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value weighted index (stock price times number of shares outstanding), with each stock's weight in the Index proportionate to its market value. The "500" is one of the most widely used benchmarks of U.S. equity performance." 
• The S&P500 can also be decomposed into subgroups that include health care, capital goods, utilities, technology, and financials. Some of the companies that are included in the index are Boeing Company, Archer-Daniels-Midland, Ford Motor, Coors, Intel, Microsoft, Oracle' Time Warner, General Mills' Nike, Merck, and Proctor & Gamble.

NASDAQ, NASDAQ web site. 

• The two primary indicators of performance are the NASDAQ Composite and the NASDAQ 100.  Included on NASDAQ 100 are 3M, Adobe, Biogen, Cisco, Dell, HBO, Microsoft, Netscape, Staples, and Sun Microsystems.  

International exchanges: In the WSJ you will find a table that has headings similar to what appears below.  The table contains summary data on a number of indexes for countries including Hong Kong where the index is called the Hang Seng.   On the day recorded here, the market closed at 8598 which was down 13.81 points from the day before (NET CHG) - a .16 percent drop (PCT CHG).  Since the beginning of the year the index has fallen 2124 points (YTD NET CHG) which represents a 19.81 percent loss (YTD PCT CHG). [You can certainly see the impact of the Asian Crisis in these numbers].

What has happened to the price of stock?

Dramatic swings in the stock market make news and we have had some dramatic swings - 1929, 1987, and 1998 being three of the most notable swings.   Below is a graph of the Composite Index which is an average based on all of the stocks on the new York Stock Exchange.   Between 1955 and 1997 the index increased a remarkable 2000%, rising from 21 to 450.

How do you account for inflation?

What are mutual funds?

• According to the US Securities and Exchange commission, mutual funds offer certain advantages to small investors.
  • Mutual funds are managed by professional money managers.
  • By owning shares in a mutual fund instead of buying individual stocks or bonds directly, your investment risk is spread out.
  • Because your mutual fund buys and sells large amounts of securities at a time, its costs are often lower than what you would pay on your own.

 How do you follow the stock markets? 

Bonds

• What are bonds?
• Who issues them?
• Why would you own them?
• What is the relationship between interest rates and bond prices? 
• How safe are bonds?
• How do you follow them in the financial press?

What are they? Bonds as IOU's

  - a promise to pay a certain sum of money in the future. For example, you could buy a promise to pay you $1000 at the end of year 1 and 2 and $11,000 in three years. 

Who issues them?  Lot's of people

• Corporations (Aaa ... junk bonds)
• State and local governments
• State agencies (UC bonds)
• Federal government (savings bonds)
• Foreign governments

Why would you own bonds? You can make money

1. hold onto the bond and collect the scheduled payments.  Returning to the opening example, you would hold on to the bond and collect  $1000 at the end of year 1 and 2 and $11,000 in three years.
2. You could make additional money if the bond increased in value.  In this sense it is just like owning a house, stock, antiques, and art that appreciate in value.  In our opening example, it would be possible that you paid $10,000 for the future stream of earnings - $1000 at the end of year 1 and 2 and $11,000 in three years - but that now you find its price has risen to $11,000 or fallen to $9,000.  To understand the changes in the price of bonds, we need to look at the link between the price of the bond and interest rates.   

Why is the relationship between interest rates and bond prices? A detailed look

• Savings bond

PV(8%) = $25/1.0810 = $25/2.16 = $11.58

• Government security

PV(8%) = 100/1.08 +100/l 082+1100/1.083

$92.59 + $85.70 + $873.20 = $1051.50

How safe are bonds? Sources of risk

• Default risk
• Interest rate risk

PV(8%) = 100/1.08 +100/l 082+1100/1.083

$92.59 + $85.70 + $873.20 = $1051.50

PV(12%)=100/1.12+100/1.122+1100/1.122

$89.30 + $79.70 + $783.00 = $952.00

How do you follow bonds in the financial press?

Hard copy: You will find something that looks similar to the table below in the WSJ.  

• Rate: the coupon rate - the rate at which the bond was issued.   This bond was issued with an interest rate of 5.75. 
• Mo/Yr: the date at which the bond will be redeemed. This bond is due in October of 2002
• Bid: highest price being bid by buyers for $100 bond.  The buyer is willing to pay $100.15 for a bond with a face value of $100.
• Asked: lowest price being asked by sellers for $100 bond.   The seller is willing to sell a $100 bond for  $100.17.
• Chg: change in the bid price
• Ask Yld: the rate of return on the purchase of the bond at the bid price.  The buyer of this bond will earn 5.61 percent on the investment.

Electronic on-line sources:

• Bonds On-line
• Bonds Online: A guide to Treasury and US Savings bonds
• bond calculator.

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