Professional Documents
Culture Documents
Module 1
Introduction
Financial institutions are a pillar of civilized society, directing resources across space and time to their best uses,
supporting and incentivizing people in their productive venture, and managing the economic risks they take on.
VaR
VAR in finance means two things, variances and "value at risk", but when the A isn't capitalized, it means at risk.
Value at risk is usually quoted in units of $ for a given probability and time horizon.
1% one-year VaR of $10 million means 1% chance that a portfolio will lose $10 million in a year
Stress Tests
Originally the term referred to a medical procedure to test for cardiovascular fitness.
OFHEO(Office of Federal Housing Enterprise Oversight) started testing firms' ability to withstand economic crisis
before the 2008 crisis.
S&P 500
Hang in the investment.
Standard deviation of Apple capital gain in decade shown is 12.8% a month, while standard deviation of S&P
500 return in decade shown is 4.7%.
Apple is more variable than S&P 500. Apple overeact to what happens in the aggregate stock market.
Beta
The CAPM (Capital asset pricing model) implies that the expected return on the ith asset is determined from its
beta.
Beta(β) is the regression slope coefficient when the return on the ith asset is regressed on the return on the
market.
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By construction, the residuals or error terms in a regression are uncorrelated with the fitted or predicted value.
The variance of the return of a stock is equal to its beta squared times the variance of the market return
(systematic risk) plus the variance of the residual in the regression (idosyncratic risk).
This is the normal distribution with standard deviation of 1 and 3, but this is not common in finance.
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Cauchy distribution is actually a fat tail distribution, and it looks quite similar to Normal distribution.
Covariance
Risk is determined by covariance.
We need stocks that are independent, so lower the covariance.
.
Cov(r,r market )
βi =
Var(v market )
Insurance
Risk Pooling
If n policies, each has independent probability p of a claim, then the number of claims follows the binomial
distribution. The standard deviation of the fraction of policies that result in a claim is
p(1 − p)
√ .
n
Policyholder's losses that are no more than 50,000 yuan (US$7500) will be fully covered by the fund
For losses in excess of that number, the fund covers 90% of the extra for individual policyholders and 80% for
corporate policyholders.
Required employers with 25 or more employees to offer federally certified HMO options.
Designed to overcome moral hazard problem, doctors earning fees for procedures make more money if people
are sick.
U.S. Emergency Medical Treatment and Active Labor Act (EMTALA) 1986
Requries hospitals and ambulance services to provide care to anyone needing emergency treatment
An "unfunded mandate".
TRIA, 2002
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Before 11/09/2001, insurers generally did not exclude terrorism risk, which they then saw as inconsequential.
After 2001, insurers wanted these exclusions.
US Terrorism Risk Insurance Act of 2002 (TRIA) required to insurers to offer terrorism insurance for three years.
Government agreed to pay 90% of insurance industry losses above a deductible of $100 billion.
December 2005, TRIA renewed for two more years, and in 2007 for 7 more years. In 2015, the act was renewed
again to 2020.
Diversification of ownership
If people are all calculating with the same data, all wanting to hold portolios on the frontier, then they all want to
hold the same portfolio.
So that HAS TO BE THE MARKET PORTFOLIO.
Portfolio Diversification
All that should matter to an investor is the performance of the entire portfolio.
Mean and Variance of portfolio matter.
Law of large numbers means that spreading over many independent assets reduces risk, has no effect on
expected return.
CAPM
International Evidence
Medial real stock market appreciation rate for 39 countries 1926-1996: 0.8% per year.
Real stock market appreciation rate for US 1926-1996: 4.3% per year.
US equity premium may reflect a selection bias.
Beta
Apple has beta at about 1.5 > 1, showing its strength in the market.
Gold ahs a negative β. So when market is doing good, gold might not have a good return, but when market is
during a recession, gold might have a good return.
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r i = r f + β i (r market − r f )
Short sales
Portfolio Variance is
∣
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Brokers can enable you to hold a negative quantity of a tradable asset: they borrow the security and sell it,
escrow the proceeds, you receive the proceeds, owe the security.
Invest x dollars into the risky asset and 1 − x dollars into the riskless asset.
The Risky asset returns r while Riskless asset returns r .
1
Portfolio Variance is
2
f
r = xr 1 + (1 − x)r f .
x Var(return1).
r − rf
r1 − rf
σ(return1).
r = x 1 r 1 + (1 − x 1 )r 2 .
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x x x(1 + g)
PV = = + +. . . . ,
r − g 1 + r (1 + r)
2
where r is the rate of discount, g is the growth rate and x is the revenue production in the first year.
For example in 2000, the best thing to invest was railroads not dot-com stocks because they failed to use the
formula.
Module 2
Limited Liability
Divide up an enterprise into shares, and no shareholder is liable for more than he or she put in.
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Forecasting
Random Walk:
x t = x t−1 + ε t .
Here is the comparison between two models and we see that AR-I model has a tendency to come back to the
starting point, while random walk not.
Intuition of Efficiency
Whatever stock market does is right. Trust the prices you see.
Weak form market efficiency: prices incorporate information about past prices.
Semi-strong form: incorporate all publicly available information.
Strong form: all information, including inside information.
Price as PDV
If earnings equal dividends and if dividends grow at long-run rate g, then by growing consol model
E P I
P = , = .
r − g E r − g
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Doubting Efficiency
The experience of living through a crash makes it obvious that human emotions play an important role.
Their confidence diminshes as he talks to people or hears from the news.
Stock market prices go down in advance of recession (two reasons): Market causes the recession; Market is a
fortune-teller.
Prospect Theory
Prospect Theory
Two elements, value function(replace utility function) and weighting function(replace probability).
Elements replace utility function and probabilities in expected utility theory which has dominated economic
thought.
People tend to gamble over the loss or they worry too much about small details instead of the big idea. (Because
you are not an engineer who tries to consider every aspect of the invention you created)
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Logical Fallacies
Cognitive Dissonance
Mental conflict that occurs when one learns one's beliefs are wrong, avoidance behavior.
Ads for recently purchased cars (Once you bought the car, you tend to read more about the ads of your
purchased cars instead of other cars because you are tryting to make you feel better.)
If the stock price of your purchased stock goes down, you might feel you were wrong at first, but then just
ignored it as you never bought.
Displosition effect
Will Goetzmann and Nadav Peles Cognitive Dissonance and Mutual Fund Investors
Found that even badly performing mutual funds retain some investors.
Brain
Mental Compartments
Shefrin & Statman: Investors have a 'safe' part of their portfolio that they will not risk, and a 'risky' part of their
portfolio that they can have fun with.
Option salespeople use these tactics: buy a put option on a single stock.
Attention Anomalies
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Anchoring
Examples: stock prices anchored to past values, or to other stock prices in same country. Do splits to keep at $30?
Representativeness Heuristic
People judge by similarity to familiar types, without regard to base rate probabilities.
Tendency to see patterns in what is really random walk.
Stock price manipulators try to create patterns to fool investors. Short a stock and create a head & shoulders.
Disjunction Effect
Magical Thinking
Magical thinking
Pseronality Disorders
Suicide rates differ across countries for no more reason than different cultural themes.
Module 3
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The following is the EONIA (European Over Night Index Average is European Counterpart to Fed Funds)
Too much cash need insurance because they are feared to be stolen, also trucks and other costs like big valut.
Therefore they want consumers to spend more moeny
Usually 3% - 5%.
Compound Interest
Compound Interest
2
)
2t
after t years.
If compounded n times per year, balance is (1 + r
n
)
nt
after t years.
Continuous compounding, balance is e . (Taking the limit of the above formula.)
rt
Discount Bonds
Discount Bonds
1 1
P = , P = r
.
(1 + r) T (1 + ) 2T
2
(I +r)
n
.
1 1 1 100
P t = c( − ) + ,
r (1 + r)
T r (1 + r)
T
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and
c 1 1 1 100
Pt = ( − ) + .
2T 2T
2 r/2 (1 + r/2) r/2 (1 + r/2)
Forward Rates
Forward rates are interest rates that can be taken in advance using term structure.
2 k k−1
(1 + r 2 ) = (1 + r 1 )(1 + f 2 ), (1 + r k ) = (1 + r k−1 ) (1 + f k ).
Inflation
Nominal rate quoted in dollars, real rate quoted market baskets (price index).
Nominal rate usually greater than real rate
Leverage
The start of the 2008 world financial crisis had to do with home buyers in U.S. and elsewhere borrowing to buy
homes.
China today is a highly leveraged economy, arousing concerns.
Debt leads to bankruptcies, possible world crises.
Market Capitalization
The Corporation
Board of Directors
In U.S., Board is commonly chaired by CEO, but CEO is hired by the Board.
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In Germany, firms have two boards of directors. There is the Aufsichtsrat (Supervisory Board) and the Vorstand
(Management Board).
For-profit corporation is owned by shareholders, equal claim after debts paid, subject to corporate profits tax.
Non-profit is not owned, self-perpetuating directors. Not subject to corporate profits tax.
For-profit exists to benefit shareholders, non-profit does not.
So for-profit has a price per share, non-profit does not.
Corporate Charter
The Basic Corporate Charter Says All Common Shareholders Treated Equally
Charter does not say that the firm ever has to raise debt. Board decides.
Charter does not say that the firm ever has to pay dividends. Board decides
Charter does not say that the firm ever has to repurchase shares. Board decides.
Charter does not say that the firm ever has to issue warrants, convertible debt, anything else
But the shareholders elect the board.
Classes of Shares
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How do Corporations Raise Money?
This dilutes existing shareholders, since they now own a smaller fraction of the company, but offsetting that, it
creates new earning power for the company.
Shareholders at a meeting could ideally vote on whether they think the prospective profits are worth the dilution,
and prospective purchasers of the issue could ponder whether they feel the diluted shares are worth purchasing.
Dilution
Dilution
If the company gives away new shares, my shares become worth less; that is dilution.
If the company sells new shares at market price, that generally does not lower the value of my shares because the
company has the money.
If the company issues a stock dividend at 5, then that lowers the value of my orginal shares by factor 1
1.05
, but I
am not worse off since I have an additional 0.05
1.05
of value in the new shares.
Share Repurchase
Share Repurchase
The opposite comes when a firm buys its own shares on the market.
The value of the firm should go down by the amount they spent.
I as a shareholder, however, now own a larger share of the company.
If the firm repurchases shares instead of paying dividends, then my shares do not lose value, the company loses
value but I have a bigger share in it.
Tax break for investors (obsolete in sense that tax rate on cap gains = that on dividends, but cap gains tax can be
postponed).
Firms' unwillingness to cut dividends, uncertainty that current earnings will continue.
Price pop after a repurchase. Buybacks taken as a signal. But price pops are fading.
Now investors sometimes view repurchase as a sign that firm is 'old economy'. NASDAQ firms less likely to
repurchase shares, as if they think value is too high.
If earnings equal dividends and if dividends grow at long-run rate g, then by growing consol model
E I
P = , P /E = .
r−g r−g
So efficient markets theory purports to explain why P/E varies across stocks in terms of r and g.
Efficient markets denies that any rule works other than simple diversification.
Value investing says invest in low P/E.
Even when there was a stronger tax advantage to capital gains, firms paid dividend.
Framing matters. Dividends framed as income.
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Dividend Signalling
∞
k
DI V t = ρτ ∑(1 − ρ) EP S t−k .
k=0
Proposed to substitute stock dividends for cash dividends, and offered to sell the stock dividend for any
stockholder for minmal transaction cost.
Direct saving to shareholder: $4 million a year.
Intense negative shareholder reaction.
Module 4
General partner runs the business, does not have limited liability
General partner must own at least 1%.
Limited Partners are passive investors, with limited liability, rights to vote, can replace general partner.
General partner or associate usually runs the offering to sell units to investors.
REITs
Real Estate Investment Trusts (REITs) were created by US Congress in 1960 to allow small investors access to real
estate investment.
Before 1960, public companies that owned real estate would be considered businesses, for which their earnings
would be subject to corporate profits tax. Until 1960, real estate was typically owned by partnerships, not suitable
for small investors.
Restrictions on REITs
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It had something to do with the free market revolution that started in Britain with Margaret Thatcher and in the
United States with Ronald Reagan, and then in China with Deng Xiao Ping.
Mortages part 1
Mortages part 2
Kinds of Mortgages
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Private Mortgage Insurance (PMI) is a type of insurance that protects lenders in the event that a borrower
defaults on their mortgage loan. PMI is typically required by lenders when a borrower makes a down payment of
less than 20% of the home's purchase price.
Companies, such as MGIC, insure Fannie & Freddie against losses on their mortgages.
Controversy: with recent real estate price increases, LTV(Loan to value ratio) has declined below 80% for many
homeowners still paying for mortgage insurance. The PMIs don't notify them.
Collateralized Mortgage Obligations (CMOs) are a type of investment security that is created by pooling together
individual mortgage loans and then dividing the pool into smaller pieces or tranches that are sold to investors.
CMOs divide the cash flow of a mortgage pass-through security into a number of tranches in terms of
prepayment risk.
Sequential-pay CMOs (first created 1983): First tranche receives first principla payments, after it is paid off the
second tranche receives principal payments.
Collateralized debt obligation, commonly known as CDO, is a type of structured financial product that pools
together a diverse portfolio of debt securities and creates different tranches or slices of varying levels of risk and
return. These securities are then sold to investors.
Hold securities, typically mortgage securities as their assets.
Typically hold subprime mortgages.
CDOs divide the cash flow into a number of tranches in terms of default risk.
CDO debt crisis 2007.
Criticism of rating agencies for not downgrading them.
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There will be a new bubble after 2007 crash in the housing markets, especially in some emerging markets like
China.
The housing values in Guangzhou are more expensive than in Manhattan, but the average salary is not the half of
the Manhattan's.
Parents are helping out. The total value of land in China is high relative to their GDP, and the price to rent is high.
It is difficult for Chinese to invest abroad, there are limits on how much they can put abroad. There's a fear of
corruption in China, a fear of being taken advantage of, so they might tend to prefer investments in a house that
they can see. Xi Jin Ping is trying to combat corruption, but there is still a public perception.
Save money and buy a house for the son, so that he can impress young woman.
All kind of Chinese facotrs that has been driving home prices up there.
Regulation Overview
Without regulation, people are forced to dothings in a competitive system that they think are bad for society.
Forced to lowest common denominator.
Analogy to having a referee at a sports referee.
Players hate referees, but without them they know game would deteriorat into something ugly.
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Tunneling
Asset sales
Contracts, as for prices paid for inputs
Excessive executive compensation
Loan guarantees
Expropriation of corporate opportunities
Dilutive share issues
Insider trading
Local Regulation
Banking Regulation
Regulates the offering and sale of securities to protect the public from fraud, regulates brokers and advisors.
Securities and Exchange Commission (SEC) part of Roosevelt's New Deal, 1934.
Initially viewed by business as a radical, almost socialist, institution. Peculiar that it started in US, imitated by
other countries.
Hedge Funds
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Front-Running occurs when a broker buys shares in front of a large order that will boost stock price.
Decimalization on NYSE and Amex begain January 29, 2001.
Decimalization favors front-running.
FASB officially recongnised as authoritative by SEC in 1973. Though SEC has statutory right to make accounting
standards, perfers private sector do it.
Earnings Definitions
GAPP Define "Net Income" which is the bottom line, traditionally and "operating income", revenue minus cost of
doing business
Operating earnings, Core Earnings, Pro Earnings, EBITDA, and Adjusted Earnings are not GAAP.
FASB is at work on developing new definitions, but this takes years.
Many home buyers were put into unsuitable mortgages, later to default.
Leverage ratio of the financial sector was allowed to reach historically high levels.
Banks and governments used off-balance-sheet accounting to conceal liabilities.
International Regulation
G20
Group of Twenty Finance Ministers and Central Bank Governors (G-20, G20, Group of Twenty)
Founded 2008
Final Thoughts
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Module 5
Forward Contracts
Forward Contract
Forward is just a contract to deliver at a future date (exercise date or maturity date) at a specified exercise price.
Example: Rice farmer sells rice to warehouser.
Example: Foreign Exchange forward. Contract to sell pounds for yen.
Both sides are locked into the contract, no liquidity.
(L − R) × D × A
Settlement = .
(B × 100) + L × D
Future Contract
Futures Contracts
Futures contracts differ from forward contracts in that contractors deal with an exchange rather than each other,
and thus do not need to access each others' credit.
Futures contracts are standardized retail products, rather than custom products.
Futures contracts rely on margin calls to guarantee performance.
Rice Futures
Begun at Dojima, Osaka, Japan in 1670s. World's only futures market until 1860s.
Dojima was centre for rice trade, with 91 rice warehouse in 1673. Rice is the underlying primary market.
Dojima futures exchange had precise definitions of quality, delivery date and place, experts who evaluated rice
quality, and clearinghouses for contracts. These are derivatives.
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When one 'buys' a futures contract, one agrees with the exchange to a daily settlement procedure that is only
loosely analogous to buying the commodity. One must post initial margin with the futures commission merchant.
Same as when one 'sells' a futures contract, no intention of selling the commodity. Again, post margin.
Daily Settlement
Every day, the exchange defines a price called the 'settle' price, which is essentially the last trade on that day.
Every day until expiration a buyer's margin account is credited with the amount: change in settle price × contract
amount.
If contract is cash settled, on the last day the margin account is credited with × contract amount.
If contract is physical delivery, on last day buyer must receive commodity.
r = interest rate
s = stoarge cost
r+s = cost of carry
Futures price is normally above cash price (contango), otherwise, 'backwardation'.
Oil Future
Oil Futures
Crude light sweet oil contract size: 10000 barrels, open interest 431,000 contracts. Physical delivery.
Brent crude, North Sea contract.
OPEC
Organisation of Petroleum Exporting Countries established 1960 by Iran, Iraq, Kuwait, Saudi Arabia and
Venezuela.
OPEC is weak today because of conflict in middle east, hence low oil prices.
In 2000, President Clinton established a 2 million barrel heating oil reserve in New York and New Haven to help
stabilise US heating oil prices. US consumption of heating oil about 100 million barrels a year.
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Fair value:
F = P + P (r − y),
where F = fair value futures price, P = Stock price index, r = financing cost (interest rate), y = dividend yield.
Options Overview
Options
Exercise date
Exercise price
Definition of underlying and number of shares.
Theoretical Reason: Kenneth Arrow argued that a major source of economic inefficiency is the absence of
markets for risks.
Stephen Ross argued that financial options have a central place in the form of "completing the market".
Ubiquity of Options
Ubiquity of Options
Options Exchanges
Chicago Board Options Exchange, a spinoff from the Chicago Board of Tradae 1973, traded first standardised
options.
Futures exchanges trade options on futures.
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Put/Call parity
Put option price - call option price = present value of strike price + present value of dividends - price of stock
Price of stock = call price + pdv strike + pdv dividends - put price
For European options, this formula must hold, otherwise there would be arbitrage profit opportunities.
To put a floor on one's holding of stock, one can buy a put on same number of shares.
Alternatively, one can just decide to sell whenever the price reaches the floor.
Module 6
Investment banks do not accept deposits, and have not been regulated as banks.
Investment banks traditionally are not members of the Fedral Reserve System and do not normally access
discount window.
Investment banks underwrite of securities rather than make loans.
Investment Banks
Traditional US bulge-brack firms: First Boston (acquired by Credit Suisse), Goldman Sachas (now a bank holding
company), Merrill Lynch (now part of Bank of America), Morgan Stanley, Salomon Brothers (merged into Citicorp),
Lehman Brothers (bankrupt 2008)
Originally were usually partnerships, but partnership form has been disappearing, resulting in greater risk taking
and crisis.
Underwriting of Securities
Firms have incentive to issue shares when they know their earnings are only temporarily high.
This problem can be "solved" by resorting to bank loans instead of new equity.
Problem can also be solved by issuing security with an investment bank that has a reputation to protect.
Studies show that investment banks that repeatedly underprice or overprice issues suffer a market share loss
afterwards.
Bought deal: The underwriter agrees to buy all shares that are not sold.
Best efforts: The underwriter says that if the issue is not sold, deal collapses
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The Underwriting Process I
Prefiling period.
Advise issuers about their choices.
Agreement among underwritiers, designates manager, fees.
Filing of registration statement with SEC, begins cooling-off period.
Cooling off period - distribute preliminary prospectus, nothing else.
Stabilization
A form of market manipulation by the underwriter near the time of the issue that is permitted by SEC.
Underwriting syndicate legally allowed to conspire to 'fix' prices in market until entire issue is sold out.
IPOs
Although average IPO earns a +16% return on the first day, this return tends to be offset over the next three
years.
With the care, skill, prudence and diligence under the circumstances then prevailing that a prudent man acting in
a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and
with like aims.
Financial Advisors
Anyone who advises others on the value of securities or advisability of investing or who publishes analysis.
Exclude banksers, lawyers, reporters, professors.
Exclude Broker Dealers whose advice is only incidental to their business.
Financial Planners
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Mutual Fund History
First Exchange Trade Fund: Standard & poors Depositary Receipts, AMEX 1993
SPDRs hold portfolio of S&P index
Management fee: low, like 12 basis points.
Brokers
Brokers act on behalf of Others as their Agent for which they earn a Commission.
Dealers
A Dealer always act for Himself, in other words as a Principal in the transaction for which he makes a Markup.
Stands ready to buy and sell at posted prices, bid and asked, profit from bid-asked spread rather than
commission.
Analogy to antiques dealers.
Dealers pay ordinary income on capital gains in US. Real estate has to be held for a substantial time between
sales anyway, so you could qualify for long-term capital gains if not a dealer.
Exchanges
Chinese investors tend to trade stocks that are locally listed, by Yale's former student Ning Zhu.
Stocks co-move more with co-listed stocks.
No information advantage.
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Kinds of Orders
Market Order
Limit Order
Stop Loss Order: Market orders dangerous for thinly-traded stocks; ECNs may not allow market orders.
Government debt
Governments all over the world regulate business. Sometimes governments will own shares in private businesses.
Private businesses know they may be nationalised in the future.
Personal Bankruptcy
Municipal Finance
People move in and out of locality, sometimes there is a reasonable prospect of future population infow,
With steady population growth, cities should borrow to finance construction of roads, swers, etc. to be ready for
them, and they should pay for it when they arrive by paying texes to pay the debt.
Connecticut adopted a constitutional amendment in 1991 against deficit spending on the general account at
time that is instituted a state income tax.
Can still run deficit on capital account.
Revenue Bonds
Social Insurance
After Civil War, compliance declined, estimated that in 1872 only 10% of eligible taxpyaers actually paid.
Tax rescinded 1872.
Survivors Insurance
Module 7
Nonprofits
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Nonprofit organisations
In 2013, there were 1.41 million nonprofits in the U.S., their revenues amounting to 5.4% of U.S. GDP.
42% of all nonprofits have a formal executive bonus system in place (2007-2008) and the percent is increasing.
Nonprofits have to compete with for-profits.
It may not be much different to you than setting up a for profit, and it gives you the moral high ground.
Example: You decide that your town needs a hospital. You create a nonprofit hospital. You go to the biggest
church or temple in town, ask to use their name and help.
Alternative Forms
Benefit Corporation
Democratisation of Finance
Nature Conservancy
World Wildlife Fund
Wildlife Conservation Society
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There will be Wars & Chaos
After World War II, US government forced the zaibastu (the big four are the Big Four zaibatsu of Mitsubishi,
Mitsui, Sumitomo and Yasuda) to sell their assets & invest in nominal yen bonds.
Mathematical Finance
The world will never be the same again beacuse of the development of mathematical finance.
The theory of allocation of scarce resources was not understood by most people ine arly 20th century.
Behavioral Finance
Behavioral finance is the salvation of mathematical finance, for it explains the frictions that inhibit it.
Releases
No releases published
Packages
No packages published
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