Friday, February 27, 2009

Asset Pricing 101

Peter Wallison has an opinion piece about valuing bank assets in the Wall Street Journal. A quick summary:

Both taxpayers and banks could come out well -- and so would our economy -- if the government were to buy the assets at their "net realizable value," which is based on an assessment of their current cash flows, discounted by their expected credit losses over time.
The article is a real world confirmation of the basic principle underlying all introductory finance courses: assets are worth the present value of their expected cash flows. This is what market value should be if the market is functioning properly. Clearly, the market for mortgage-backed securities isn't functioning at the moment.

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Replies

Thanks for replying in the comments. It makes the blog more interesting to write, as well as more interesting to read.

Sheldrick -- enrollment is now up to 885. It's not that there's a shortage of lecturers, but that the model is a bit different here in Australia. Undergraduate classes are set up as large lectures with tutorials. My students attend one 2-hour lecture per week, and one 2-hour tutorial per week. The lectures are huge -- final year finance electives have 300+ students and my second year introductory course gets 700+ every semester. Our largest lecture theater seats 460 -- so I give the same lecture twice each week. Tutorials are smaller groups, run by grad students. Class size is limited to 25. Tutorial activities include going through the homework and working through questions in class.

Dave -- thanks for the link to Quiggin's post on Taleb. I found the comments on that post very informative. I quite agree with those commenters that Taleb can seem quite arrogant at times. I do try to follow John Quiggin's blog (after all, his office is just upstairs from mine), but generally through Google Reader, so I miss out on the comments.

Tuesday, February 24, 2009

Getting Ready

Next week marks the beginning of a new academic year here at UQ. I'm teaching two courses this semester -- an introductory finance course for business majors (over 850 students), and a personal finance course with no pre-requisites (over 100 students). If any of my students find their way here, do say hello in the comments.

So, what have I been up to since my last post? Well, I've been reading a lot. As I stated last time, I'm working my way through Fooled by Randomness by N. Taleb. I'm finding this book a frustrating and interesting read all at the same time. Interesting because Taleb has a unique perspective on risk that is quite instructive. Frustrating because it doesn't really offer an alternative.

In finance we teach that expected risk and return is the basis for sound financial decisions, then usually measure that expected risk and return by looking at historical numbers. Taleb rightly points out that historical returns are just one realization of the possible random paths that returns might have taken, and therefore may not reflect the random paths that returns might take in the future.

Over at Portfolio.com, Felix Salmon has posted a link to his very interesting article in Wired Magzine about the credit crisis. It points out, in a clear and entertaining fashion, how important it is to understand the model outputs that you use to make investment decisions.

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