Shameless Promotion

I created a funding project on indiegogo for a video series I have wanted to make for quite some time.

This video series is to teach basic personal finance. Too many times we expect an 18-22 year old person to make sound financial decisions. This is not reasonable because we do not teach the necessary skills, generally, to teenagers. This is also not fair because poor choices will have long term consequences. A bad credit record will impact the rate one gets on a loan, if credit will be extended for a needed purchase and if one can get a high income job.

Please consider sharing this project with your friends.

Understanding Insurance

In keeping with my earlier post explaining what money actually was, I am going to use this post to explain insurance.

Definitions

Insurance is simply the transfer of risk from one party (the insured) to another (the insurer) for a payment. The payment is called the premium. This premium is equal to the expected loss during the insured period plus some additional amount to pay administrative and operational costs of the insurer and build available reserves. The process of accessing the risk, determining the price of the risk, and deciding if to take on the risk exposure is called underwriting. When a loss occurs, the insured makes a claim and the insurer then indemnifies, or makes whole, the insured.

Insurability

For insurance to “work” there need to exist insurability. There are several characteristics which will exist if a risk in insurable. If they do not exist then the risk must be transferred either through a compulsory insurance program such as workers compensation or social insurance such as social security disability insurance or through other techniques which I will address in future posts. I will use an example for each of these with the insurance company insuring $200,000 homes which have a 1% chance of a total loss due to fire and a 99% chance of no damage.

  1. Definite loss: The loss has to have a clear cause that took place at a particular time and place. In our example the cause of the loss would be the fire which occurs at the home’s location and we could clearly have a time of the event.
  2. Accidental loss: The loss has to be fortuitous to the beneficiary. That simply means that the loss needs to be outside of the insured control. In our example this would mean for instance that the fire was not arson by the beneficiary or at the beneficiary’s request.
  3. Calculable loss: The loss needs to be both of a calculable chance of occurence and of an estimated size. In our example we have a 1% chance of a loss and that loss is of $200,000.
  4. Large loss: The loss has to be economically significant. If the loss potential is too small then it is not worth the effort to underwrite the policy and administer it. In our example we have a total loss so this is not a concern because it is clearly economically significant.
  5. Affordable premium: The premium for that loss calculated above cannot be so great that the insured will not pay (for the risk of occurence is too high as an example) or so great that the insured is not at risk (because the cost is too high for the risk insured). We do not state a premium in our example but an actuarialy fair premium would be $2,000 for a year. The premium would be higher than this because of loading. This loading is how insurance companies pay for the administrative costs and generate an underwriting profit.
  6. Large number of similar insurable interests: This means that the insurer needs to insure a pool of homes that are similar in their risk exposure. This is because as the number of units grow we can use something called the “law of large numbers” to assume a normal distribution of losses. With one home the expected loss is $2,000 and the standard deviation of the loss is almost $20,000. If this were a pool of 10,000 homes, the expected loss per unit is $2,000 but now the standard deviation is just over $2,000.
  7. Limited risk of catastrophe: The individual trials should be independent. This means that there would not be a giant conflagration which burns a large number of the pool. Catastrophic losses defeats the advantage of pooling.

Role of Insurance

Insurance is one of the techniques to manage a risk. As the list above shows, insurance works well when you have rare events which result in large losses and those losses are independent of each other. If the size or frequency do not fit this pattern, then risk management is still important but other tools must be used instead.

In my next post I will look at the example of the health insurance industry in the United States and discuss if it is appropriate to consider it to be an example of insurance in our description above.

Insider Trading – Is It As Bad As You Think?

When most of us hear the words “Insider Trading”, we feel a little chill down our spines.  It is a bad thing of course, isn’t it?  Recent insider trading scandals like the case with hedge fund manager Raj Rajaratnam of the Galleon Group reverberate through our minds.  It is something that should be punished criminally, and eliminated from the markets if at all possible.  But anyone especially interested in this phenomenon should really stop and ask again that age old question that has plagued market regulators – is insider trading truly a bad thing? 

For that matter, do we even know what insider trading really is?  In the 1980’s and 1990’s, many famous insider trading cases appeared headlining the news.  This spate of illegal insider trading renewed interest in increasing regulation of these types of trades, and the question of how to define insider trading moved to the forefront.  Previously, legal insider trading had been mostly defined as trades by top executives or beneficiaries of corporations or their family members.  But couldn’t others outside this group obtain information that could move the stock price, and illegally benefit? And how exactly would those cases be defined as illegal? Michael Milken was one of the most famous illegal inside traders in the late 1980s, but it was not always clear that what he was doing was illegal. And how could regulation possibly define all the ways that one could obtain this inside information illegally?  Congress is famous for massively long bills, but the ways to trade on inside information are almost infinite.  So in 2000 a much more practical bill called Regulation FD was passed, broadly defining illegal insider trading as “anyone who trades on material, nonpublic information”.

Ok, so now we know what insider trading is.  However, before I go further, it is important to make a more clear distinction between legal and illegal insider trading.  Insider trading is actually legal for corporate insiders and is an active part of the marketplace, but is done in a controlled, regulated fashion.  Legal insider trading is not only accepted, but is considered desirable in the markets, because it improves the chance that the stock price more fully reflects current information regarding that stock, meaning that the current stock price is more accurate (this is called in the finance literature the “price discovery” process).  Who knows better than corporate insiders if their product is selling like hotcakes and orders are increasing, or if sales are slowing down and their warehouses are filling with costly inventory?  So these insider trades send a great signal to the marketplace on which direction the stock price is likely to move in the near future, and what the current fair price of the stock should be.  And because of improvements in insider trading laws (the biggest recently being Sarbanes Oxley in 2002), insiders cannot gain much profit before revealing their information to the general public. 

Now let’s consider illegal insider trading, which is usually assumed to be harmful to investors and the marketplace.  In fact, since current laws would be expected to only allow insider trading that is not detrimental to investors, it is easier to see why these illegal insider trades might cause problems. And in contrast to legal insider trading, illegal insider trading might be assumed to make the stock price less accurate (harming the “price discovery” process).  Thus in a market with heavy illegal insider trading, the average investor would constantly be buying at an abnormally high price, and selling at an abnormally low price, with these illegal inside traders profiting off of the difference.  This behavior would discourage average investors from trading in markets like this, causing further harm to stock price accuracy, as there would be less traders doing research on stock prices, etc.  However, there is a small contingent that believes that even illegal insider trades are beneficial to the marketplace. Nobel prize winning economist Milton Friedman argued that all insider trades should be allowed for trading, even the ones currently considered illegal, as this would open the markets up to the free and unhindered flow of information from insiders to the marketplace.  Stock prices would move up or down based on this increase of insider trades, more accurately pricing the stock than what happens in our current regulated environment.  While this sounds good in theory, evidence of market manipulation prior to the 1930s when insider trading was less regulated may conflict with this opinion.  Many Libertarian think tanks argue that the market would adjust to attempted manipulation while still allowing better stock pricing, but the debate rages on.  Actually, an excellent guide to understanding the distinction between the benefits and detriments of insider trading appears in the 1987 Oliver Stone classic film “Wall Street”, in which Michael Douglas portrays a corporate raider heavily using illegal inside information.   While most of the movie focuses clearly on this undesirable illegal insider trading, there is one famous scene (often called the “Greed is good” speech) in which Douglas’ character Gordon Gekko skewers the management and insiders of Teldar Paper for not personally buying into the stock, subtly suggesting that the poor performance of the firm was because “management has no stake in the company” and was thus uninterested in actually improving firm performance.

So back to the original question – is insider trading really bad?  Always remember when answering that question to define exactly what insider trading is first.  Under the current regulatory environment, most scholars believe legal insider trading to be a good thing for the creation of more efficient markets, while illegal insider trades are considered undesirable for establishing proper stock prices.   The dividing line between the two shifts periodically with economic conditions and political parties in office, but one thing is certain – insider trading will always be with us, whether legal or illegal, so we better get used to it and try to understand it more fully.

Tony Via is a 5th year Finance PhD student at the University of Alabama, and currently resides in Tuscaloosa, AL.  He is originally from Decherd, Tennessee, and worked as a mechanical engineer before returning to graduate school.  His research specializations are in Investments and Market Microstructure, and he has done consulting work in proprietary trading and market impact models.

What is money?

What is money?

An example of US currency of several denominations

That is a question that comes up in my Money and Capital Markets class every semester. Money is just slips of paper and bits of metal to many people but that doesn’t really sound like an answer. In fact that is more of a description of currency (which makes up money) but not money itself.

Types of Money

Money is defined as anything that is accepted as payment for goods or services or as repayment of debt. Money can be based on an actual item of value such as a gold coin or a carved shell. In this case we refer to it as commodity money because it has a value intrinsic to itself. In most economies today, money is based on nothing more than the good faith of the issuing authority. We refer to this as fiat money. Fiat is Latin for “let it be” so we can tell by the name that fiat money has value because the legal authority in that specific economy says that it has value.

Uses of Money

Now that we have an idea of what money actually is, we should also keep in mind what for what we use money.

  • Medium of Exchange
  • Unit of Account
  • Store of value

As a medium of exchange, we can give money to anyone for a good or service and that person can then go and purchase the goods and services that they wish to purchase. Without having money to act as a medium of exchange I have to find someone to barter with that both has what I want and wants what I have. In economics, we call this the double coincidence of wants.

As a unit of account, we are saying that money has some standard measure of value. Each US dollar is equal in value to every other US dollar. Exactly 100 of those US dollars can be exchanged for a $100USD bill. This relationship is required or people could not set a specific price.

As a store of value, we can put money aside and then come back in the future to reclaim that value. There is a great deal of discussion about the true ability of fiat money to act as a store of value because the value is only true as long as it can be accepted for payment. This is further compounded by the inflation that occurs in modern economies which further erodes the stored value of money.

In a future post I will discuss the transition from commodity money to fiat money and the role of the Federal Reserve.

UAB Follow Up

My previous post did generate some discussion, at least on twitter, and a question was raised regarding the issue of forming a private group to build the stadium. To paraphrase, would the venture be viewed as legitimate since it is operating outside of the athletic department?

This is a good question but before I answer it, let me explain perhaps in a bit more detail what I meant by the alternative solution. This would be a private venture which would form for the sole purpose of building, maintaining, and marketing the stadium as a venue for UAB football as well as any other off season events.

(This bit is a business refresher for anyone that doesn’t deal with corporate finance often.)

As with any company there would need to be capital. The two types of capital are debt (which is a claim for a set dollar amount) and equity (a claim on residual income after debt holders are paid). If the project were built by UAB itself then no equity is possible so it is a debt issue specifically a 30 year bond issue. With a group of investors instead of the university it would be possible to have partners form and give money for an equity stake in the venture. This equity position means that less debt would be required which makes getting the debt easier.

(End of the refresher)

So if there was a group of investors that wanted to make this happen, how could they establish that they are legitimate? The first thing would be to secure property near UAB campus. This is an “On Campus” stadium but for UAB that is a good part of Southside. I am not going to pretend to be up on real estate prices in Birmingham so I do not know what it would cost to get that property, especially since it is a good bit of land and located next to UAB and medical complex. Once property is secured there would need to be a commitment from UAB that if such a stadium were built in a certain time frame that they would stop playing games in the current venue, Legion Field, and switch to the new stadium. Given the contracting this could be easy to plan for and should be something that UAB could commit to since they are currently contracting to use a private facility.

How much money needs to be raised? Well when FAU built an on campus stadium they received $12MM from a builder which they combined with campus funding for a total of $25MM and used that to help secure an additional $44.6MM, in the form of a loan, of debt. Having so much capital before the loan was required because the loan was backed only by the revenue of the stadium so Regions would be unable to go after the school itself if FAU had defaulted. The stadium has been very successful so that is not a concern.

The UAB plan would be $60MM plus the cost of securing the land and administrative costs in establishing the venture and securing investors/lenders. Getting debt of 60% of the value of the project is clearly easier than getting debt of 100% of the project so the more of their own money investors put up, the faster the process and the lower the rate.

I do not know if legally the group could take money in advance for boxes, priority seating, naming rights and the like (to be held in escrow) which could perhaps assist in demonstrating the potential cash flow for lenders. Even without such though, by having investors with an equity stake the on campus stadium could be a reality in a short period of time.

To answer the question of legitimacy, stadiums, arenas, auditoriums, fields, etc. are often run by private organizations. It is not as common that they are built without it being done through some city or state government but that is in large part due to lower cost of borrowing in municipal bonds because of their tax exempt status. If muni bonds are required then the city, county or state could get involved but given the lending issues in the past in the area that may not be easy to swing. As the FAU example showed, muni bonds are not always used and so the project could be financed without them.

In short, I think that an investor group could be formed from business people in the Birmingham area to establish an on campus stadium.

UAB On Campus Stadium Proposal

Let me preface this by putting a few things out there.

  • These are my views and do not reflect the views of my university, college, or department
  • This is based solely upon the one document that I received that was stated to be official
  • This discussion with me having not worked in sports marketing, my work experience is in manufacturing
  • I do not know if I am allowed to host the document, if I receive word that I can I will put up a link

Now that we have those details out of the way, let me talk about the background to the proposal. The University of Alabama at Birmingham (UAB) is a school that competes in Conference USA. The Blazers, as the team is called, currently play at an outdated facility named Legion Field. There is a push for some members of the UAB community including the Athletic Director that a on campus stadium be built. As the stadium is not part of the approved multiyear master plan the construction must be approved by the board of trustees for the entire system. The board of trustees did not put the construction on the agenda so as of this post there is no current plan to build the stadium.
The stadium proposed is a 27,500 seat “U” shaped stadium which will be located on the campus itself. This number of seats is no doubt due to the fact that they average 23,139 attendees as of last season even though the current venue seats 71,000. The proposal suggests 16,060 tickets would be sold for each of the 6 home games in addition to 1500 student tickets and the season tickets for suites, loge and club level seating. The total ticket sales of 23,497 is in keeping with the current average so on its face it is reasonable presuming the ticket prices are in keeping with that of the current venue.

There is also an assumption that they sell all boxes and 80% of premium seats. I don’t know how reasonable that assumption is but given the statement that all interviewed schools with on campus stadium wish more had been built I am willing to accept it.

I won’t go line by line for the other assumptions for revenue or expenses other than to say that the numbers were based on the numbers from Legion Field, Bartow Arena (the on campus basketball arena), and input from the other on campus stadium visited (UCF, Akron, SMU, Troy, Louisville, & FAU). If these assumptions are accepted on their face it would result in approximately $5MM a year in operating income.

This leads to the question of financing. The construction cost for this stadium is $60MM. According to the numbers presented it is assumed that this would be by a bond issue with a nominal rate of 5% and a 30 year term. That rate is similar to the issue (Aa2 rated in 2010) of $142MM based on general revenue which helped to partially fund upgrades to Bartow Arena in addition to several capital improvements on the campus.

Given all of the caveats, the plan looks viable. Perhaps the best way forward would be for a group of investors to form a special purpose group to secure the land, build the stadium, and then lease it back to UAB if the school president is unable to get it on the master plan in future Board of Trustee meetings.

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