By Hugh Edmundson, Carnegie Mellon University

Arbitrage-free pricing is the primary means of determining the fair value of a security.  The principle of arbitrage-free pricing essentially boils down to the claim that you cannot earn something from nothing without assuming some risk.

The concept of arbitrage is historically associated with price differentials between markets. As a (simplified) example, when the price of a good such as timber was lower in Market A than in Market B, merchants would purchase the timber at the lower price in Market A, transport the goods to Market B, then sell the timber at Market B for a higher price. Since prices were relatively stable, merchants could incur a risk-free profit, less the costs of transport, by simply moving goods from where they were more plentiful to where they were less plentiful. The merchants would then earn a profit based on the price difference. Over the long term, such merchants' actions would cause the two independent market prices to converse to an equilibrium.

Note: This article is part of a four-part introductory series on understanding equities, bonds, options, and foreign exchange markets.

As schools nationwide begin to fill with eager minds (and eager bodies), now is a good time to teach the basics of investing to students looking to hit the ground running at their respective business clubs or classes. So with that, we at Bulls & Bears Press are rolling out a four-part introductory series covering the underlying basis of several major asset classes, including equities, bonds, options, and currencies. These articles will not teach you to make millions, but rather provide a fundamental understanding of what drives these assets so that with the right training and work, you can make millions.

By far one of the most popular vehicles of investing, stocks (also referred to as equities) have gained tremendous popularity with the advent of electronic trading and the tech-bubble of the late 90s. With daily upswings over 100 points in both the Dow Jones Industrial Index and the NASDAQ, the question was not what to invest in, but rather how much should be allotted to this dotcom company or that tech company. Stocks became some magical way to transform nothing into wealth overnight, without fully understanding how they work. While the ensuing crash scared off many new and would be investors, stocks were forever on mainstream America's radar from that moment.

    
     The possibility of the U.S. once again dipping into recession has become an increasingly legitimate concern as of late. In fact, many believe that recessionary times have already come upon us due to the global economic slowdown. Even in emerging markets such as China, growth has stagnated as of late, with Chinese inflation down in August. This speaks to the downturn in global industrial production, which has directly contributed to a decline in copper prices. Overall, the week of 9/19/11 has marked the steepest decline in major U.S. equity indices since October of 2008, which took place in the thick of the credit crisis. It now seems as though the Europeans are experiencing an imminent credit crisis of their own that will reverberate overseas. The lack of direction exhibited by European financial leaders has been disconcerting to say the least, as they have essentially ignored the urgings of Treasury Secretary Tim Geithner to expedite recapitalization of large banks across the Euro Zone.

       The week of 10/10/11 was eventful in the global economy and capital markets, as has been the pattern recently. Monday witnessed a 330 point spike in the Dow amidst hope that the Euro Zone saga might finally be coming to a resolution in the near future. Germany and France indicated that they are willing to proceed in the bailout of Greece, yet no definitive word on their specific plans has been reported. Chinese officials have ventured to Greece to assess the severity of the situation themselves. Even though China does not own a significant amount of Greek debt on their books, they would still be very much affected by a downturn in the global economy because they are the predominant exporting nation in the world. With an economic slowdown, their exports would fall substantially, and their growth would slow much more rapidly. Amidst the hopes of a Greek bailout, the Euro strengthened as well against the dollar, and commodity prices have risen.  Many analysts are dubious of the sustainability of this rally from a long-term perspective, however, mainly because of the continued lack of confidence and unsteady of demand in the global economy. Domestically, consumer demand has picked up, as September retail sales were higher than expected with a 1.1 % gain, quelling fears of a recession.

By Anthony LaLota, Rutgers University

        An “All or Nothing” day on Monday, Oct. 17, resulted in all major indices declining significantly, amidst further Euro Zone fears adversely affecting capital markets, as Germany casted doubts over expediency of the Greek bailout. In other foreign events, China's annual economic growth fell to 9.1 percent in the third quarter from 9.5 percent in the previous quarter, as tight domestic monetary policy and easing foreign demand hampered economic output. As a result of the stock market weakness domestically, heavy outflows into bonds took place, as the yield on the 10-year fell from 2.25% to 2.16%. Weak corporate earnings certainly didn’t help in terms of those hopeful for a sustained recovery of U.S. equities. Notably, IBM stock was down, as “Big Blue” missed earnings estimates, an unusual occurrence for the tech stalwart. Greece, however still continues to wield the most significant magnitude over the global economy, as social upheaval has begun to take place. Coined “The Week of Thrills” in reference to a 48-hour strike beginning Wednesday, as many as 50,000 to 60,000 protesters were expected to become active in public displays of social unrest last week. It is clear that the Greek saga is still the primary determinant of economic activity, and, by extension, the health and perception of global capital markets.

By Andrew Geenen, Villanova University

Last week we watched the second largest gold sell-off since 1983, begging the question from the casual investor if the ‘gold bubble’ had popped. The answer is simply NO. While gold prices did fall roughly 10% last week, this drop is likely a market correction for the rapid growth gold enjoyed this past summer. Gold prices have soared in recent months because investors have been looking for a safe haven from the remarkable market volatility and projections of slow economic growth in both the US and Europe. This incredibly rapid and constant price increases in gold has lead investors to believe gold was in a bubble and enjoying cyclical growth fueled by a tumultuous economy. Many see this growth as a ‘flight to safety’ in case sovereign countries in Europe begin to default on their bonds. While these market factors have created an environment for gold’s recent growth, this gold boom can be seen as part of a long-term secular bull market for commodities.

Analysis of Macro Environment by Anthony La Lota, Rutgers University, '13

 

Due to the ongoing political impasse in Washington and mounting concerns over Euro Zone debt contagion, confidence in the Western markets has been undeniably rattled. Further damage has been levied by S&P’s downgrade of the U.S.’s vaunted triple-A credit rating in response to turmoil over raising the debt limit. In actuality, the downgrade means little in terms of the U.S.’s solvency. Our nation’s ability to pay off its debt has not significantly changed, but what has changed is the perception of the U.S. as the world’s beacon of creditworthiness. All of this uncertainty is reflected in the VIX, widely regarded as the best gauge of volatility in domestic markets. Currently trading at 32.73, the VIX is off from a 52 week high of 48 in early August.  Nonetheless, it is still an indication of a shaky economic environment. The Thomson Reuters index on consumer sentiment remains at a similarly low level at 57.8.

By Kristin Carew, Carnegie Mellon University

Imagine that the United States has just breached the debt ceiling with no compromise in place, throwing the federal government into a state of fiscal turmoil.  

The government immediately begins efforts to delay or reduce the impact of its inability to borrow by shifting money around and pulling funds from non-essential programs.  However, investors understand that there is little hope for preventing default without a compromise on the debt limit, as the Treasury needs to roll over its debt in order to make interest payments.  Experts following U.S. political developments see that an agreement on the debt ceiling is not forthcoming.  This conclusion trickles down to investors, who realize that default is inevitable.

 By Staff Writers, Bulls and Bears Press

Standard & Poor’s, Moody’s and Fitch Ratings - what do these three companies have in common? They are the three major global ratings agencies (comprising 90-95% of market share).  They provide the service of rating debt, both on the corporate and the consumer level, to facilitate investment decisions and provide some market transparency.

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 By Daniel Griffith, Carnegie Mellon University
  
 

April 6^th, 2011 saw the first auction of mortgage backed securities that the Federal Reserve Bank of New York acquired from AIG in mid-2010, amidst skyrocketing subprime mortgage defaults and subsequent MBS pricing failures.

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