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Bryan Bailey

Pomeroy

Senior Project

May 2, 2014

The Modern Market: A General Overview and Analysis of the 2007 Collapse

For my senior project, I will examine the modern market as it relates to stocks,

including valuation, trading tools, and the complicated trading of derivatives to see how

these instruments played a major role in the economic meltdown of 2007. I will focus on

the different categories of stocks, as well as how corporate and individual interaction

affects those stocks.

Stocks are available shares of a given company, with each stock counting as a

percentage of ownership of the company. The more stocks you own, the greater the

percentage of the company you own; if you own the majority percentage of stocks, you

have control of the company. However, not all companies have the same amount of

stock, because controlling the flow and amount of stocks in the market directly affects its

price.

Investors examine stocks not for their current value, but for their potential value.

Therefore, the valuation of a stock depends on a multitude of future factors, including the

company’s projected revenue, corporate leadership, industry mergers and acquisitions,

and investor and general market outlook. There are many tools available to investors in

order to help valuate stocks, these include: the price to earnings ratio (P/E ratio), past and

projected return on investment (ROI), and the earnings per share of the stock (EPS). The
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P/E ratio, also known as “price multiple”, is the valuation of a company’s current share

price over its per-share earnings. There are different ways to use this tool, including using

a trailing P/E from the previous four quarters, or a forward P/E, using expected earnings

for the next four quarters. A high P/E implies that investors expect earnings growth in the

future, but it is in inadvisable to use solely the P/E ratios of two companies to compare

them, for there are many other factors. If a company has a P/E of 10, it suggests that

investors are willing to pay $10 dollars for $1 of the current earnings. It should be noted,

however, that P/E comparison between stocks only applies with comparing stocks within

the same industry.

The ROI is one of the simplest tools in the investor’s tool belt, because it is easy

to use and applicable throughout all facets of business transactions. The ROI is the

difference of the current asset price minus the original asset price, all over the original

cost of the asset.

(𝑅𝑅 −𝑅0 ) ∆𝑅
𝑅𝑅𝑅 = 𝑅0
=𝑅
0

The formula shows that a positive ROI means that the investor has positive return on his

investment. The inverse is also true.

The EPS calculates a company’s earnings minus its preferred stock dividend

versus its number of outstanding stocks on the market. Because the number of

outstanding shares is constantly changing, an average of the number of outstanding

shares should be used over a given time period.

(𝑅𝑅𝑅𝑅𝑅𝑅 𝑅𝑅𝑅𝑅𝑅𝑅𝑅 − 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑅𝑅 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑅𝑅𝑅𝑅𝑅)

𝑅𝑅𝑅 =
𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑅ℎ𝑅𝑅𝑅𝑅
For example, if Company A has $25 million in annual earnings, paid out $1 million in

dividends, and had an average number of 30 million outstanding stocks, then its EPS
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would be 24/30, or 0.80. A higher EPS indicates strong earning potential per stock of the

company.

However, there is also a way to speculate, or more colloquially, gamble, on the

futures of the stocks, as well as to insure against negative volatility in the stock for the

future. These investment instruments are called derivatives because they are valued based

on the underlying price of the stock, yet they depend on future contingencies. Two

common forms of derivatives are futures and options. A future is a financial contract that

obligates the buyer to purchase an asset at a predetermined date or price. Two common

types of future orders are limits and stop orders. A limit order executes the order at a

specific price; a price lower than the current market value to buy low, and a price higher

than the current market value to sell high.

Stop orders, or stop-loss orders, are tools to hedge against rapidly decreasing

stock prices as well as protect unrealized profit. Stop orders execute the sale of an asset

when it drops too low, or the acquisition of an asset when the price reaches a designated

value above the current market value. Both types of future orders can be used to leverage,

or grow your portfolio and revenue; they can be used to hedge, or insure, against risk

from other investments.

Options are very similar to futures, except that buying an options contract gives

the holder the option to buy or sell the underlying asset at the assigned price, as they are

not obligated to exercise that option as with futures. Both options and futures have

expiration dates assigned to their order; typically closer expiration dates come with

higher order prices, as it is easier to speculate on the price of a stock in a months time as

opposed to a years time.

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The United States and most of the world operates on the institution of fractional-

reserve banking (FRB). FRB is a system of banking, “… in which only a fraction of bank

deposits are backed by actual cash-on-hand and are available for withdrawal”

(Federalreserve.gov). This means that banks are required to have, in their possession,

3.00% of their total deposits at any time for institutions with less than $79.5 million in

transactions, and 10.00% of their deposits for institutions with greater than 79.5 million

in total transactions (federalreserve.gov)

This required reserve percentage means that if everybody with a deposit in a

certain bank came to collect all of their deposits at once, the back would not have but a

tenth of their total money. This can create problems when the markets falter, and deposit-

holders wish to liquidate their assets. The banks are unable to meet this demand and must

borrow money using Collateralized-Debt Obligations (CDO’s) and Credit-Default Swaps

(CDS’s), which are essentially used to protect a party against a debt crisis by the backing

of a pool of bonds, in the case of CDO’s, and bank insurance that resembles a credit

derivative in the case of CDS’s (Heinberg).

As banks feel secure using bigger banks’ and insurance agencies’ money with the

exchange of CDO’s and CDS’s to protect their liquidity, the heavily under-regulated

derivatives market have come under close scrutiny in the past decade for their

involvement in creating insurmountable sums of debt that preclude liquidity. Derivatives

and their subsequent creation of debt magnifies both the potential loss and gain of both

the holder of debt and the derivative owner; however, once growth in a derivative market

ceases, the inflated economic ‘bubble’ is popped and values plummet while debt soars.
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One of the most notable examples of catastrophic derivative valuation is AIG’s

massive collapse in the wake of the 2007 economic recession, where the government was

forced to provide $85 billion dollars worth of bailout money in order to keep the

company from collapsing (Heinberg). AIG bundled CDO’s into CDS’s, creating massive

profits for investors and insurers alike, as long as the exposed debt was not claimed all at

once. However, once the market began to fail, and banks were unable to fulfill their CDS

payments because their loans had defaulted, a domino effect occurred that toppled one of

the most prominent economic insurance agencies in the world.

AIG’s failure to properly guarantee the credit loan to banks that provided sub-

prime loans to homeowners is just one example of how corporate interaction can cause

massive upheaval in the stock market, as well as the global market. Ultimately, investor

and consumer outlook is one of the best and most basic indicators of future trends; in a

‘bull’ market, optimistic outlook sees a general upward trend in the market and the

market indices, while a ‘bear’ market sees a pessimistic and fearful outlook that leads to a

lower future valuation of stocks.

Investors that circulate money to stimulate economic growth, as well as the

current banking systems that gives out loans are the drivers of our current economic

system, one that seems infallible. However, this is not the case, as epitomized in the

economic meltdown of 2007. Stocks are traded billions of times daily, and tools such as

ROI, P/E ratio, and EPS are used to valuate a company’s stock’s potential growth. These

tools are essential in all facets of trading, including using stop- and limit- orders, which

are widely used and provide limited exposure, and futures and options, which speculate

on the growth of the market with a large amount of potential risk. When the market
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begins to become stagnant and investor optimism falls, derivatives and the incredible

amount of debt they generate create problems for an economy that can only be fixed by

bailouts and austerity packages. Investing is becoming an increasingly popular hobby

because it is easier than ever for economic enthusiasts and speculators alike to trade

online. However, as the market place becomes more populated and economic growth

increases due to the borrowing of equity to leverage assets, care must be taken to use

economic tools wisely to invest judiciously so that the marketplace can continue to grow

without the aid of debt creating stock trades.

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Works Cited

Heinberg, Richard. The end of growth: adapting to our new economic reality. Gabriola

Island, B.C.: New Society Publishers, 2011. Print.

"Reserve Requirements." Federal Reserve Bank. Board of Governors of the Federal

Reserve System, n.d. Web. 03 May 2014.

<http://www.federalreserve.gov/monetarypolicy/reservereq.htm>.

"Investopedia - Educating the World about Finance." Investopedia. N.p., n.d. Web. 01

May 2014. <http://www.investopedia.com/>.