After I left the previous post, Bogart Beck, head of SL CapEx, and I had a nice discussion about RE, the Balance Sheet, and how things are supposed to be set up. Both approaches have their merits, but I wanted to explain his side of the story (as best I can), and show why the financial templates were set up as they were. (Note to Bo: If you were to post a current financial reporting template somewhere on CapEx, that would be much appreciated!)
In my previous post, I explained that
RE(t) = RE(t-1) + NI(t) - Div(t)
Which is still true, and it's how I learned it in my first accounting class. I believe this is also GAAP-compliant. Bogart, however, wanted to make it a little easier for the average investor to be able to "follow the money" through the financial statements from month to month, and in so doing, rather confused those who were more familiar with the previously stated method.
For SL CapEx, Bogart was trying to set up a system where the RE reported on the Income Statement was directly carried over to the Balance Sheet, and what was formerly in the place of the RE on the Balance Sheet was transferred to some other account, say Capital Surplus. So, at the end of the month, here's what the (simplified) journal would look like:
Account..................................DR....................CR
Retained Earnings................RE(t-1)...........................
Capital Surplus...............................................RE(t-1)
Net Income...........................NI(t)..................................
Dividends..............................Div(t)................................
Retained Earnings...................................RE(t) = NI(t) - Div(t)
This way, an investor can look and see how the Income Statement carries through to the Balance Sheet.
However, Bogart has confirmed (I believe) that the GAAP method is acceptable as well. At least, he hasn't stopped me from using it on SLR's finances, yet. I will continue using the GAAP method, as it is the one I understand best.
Saturday, November 22, 2008
Friday, October 3, 2008
Retained Earnings
One little description, so much power. The description of Retained Earnings on the SL CapEx template balance sheet formerly read
"TAKE DIRECTLY FROM LINE 523 of INCOME STATEMENT"
And this description can still be found on a few of the financial statements running around CapEx. The unfortunate part about this description is that it is wrong. (For one, the income statement only goes to row 53 in Excel, so that should be a first clue that something is odd.)
Retained Earnings is an account in the Equities Section of the Balance Sheet. It is a cumulative (read that word again - cumulative) account of all earnings that a company has retained since inception - hence the name "retained earnings." The tricky part about this account is that it is cumulative. In order to calculate Retained Earnings (RE) correctly, you must do it from the start.
Let's think about how to calculate RE. The first question is, "What is earnings?" Most would agree that earnings can be calculated as Revenues - Expenses. The Income Statement labels that number as "Net Income," so we'll refer to earnings as Net Income (NI).
The next question is, "How does a company retain earnings?" It's actually easier to address how a company does not retain earnings, and that is by paying dividends. When a company pays a dividend, then it is distributing part of its earnings out to its shareholders, who receive them. Therefore, the part NOT paid in dividends is the part of earnings that is retained. We'll call dividends "Div."
So, then we have a formula:
(The second equation is the same as the first, but in the shorthand I noted above.) This is the exact formula that is calculated on the Income Statement, Line 53 (in the template I'm using).
The problem is that this RE is not equal to the RE on the Balance Sheet. The RE on the income statement represents the CHANGE in RE for this period on the Balance Sheet. Here's an example:
April 2008: Retained Earnings is calculated to be L$1,200
May 2008:
In words: Retained Earnings this period equal Retained Earnings last period plus net income this period minus dividends this period.
I hope that clears up some of the mystery with this line on the Balance Sheet. I see a lot of companies with incorrectly calculated RE, and it's really a pretty simple line to do. If you have any questions, feel free to leave a comment - anyone can.
"TAKE DIRECTLY FROM LINE 523 of INCOME STATEMENT"
And this description can still be found on a few of the financial statements running around CapEx. The unfortunate part about this description is that it is wrong. (For one, the income statement only goes to row 53 in Excel, so that should be a first clue that something is odd.)
Retained Earnings is an account in the Equities Section of the Balance Sheet. It is a cumulative (read that word again - cumulative) account of all earnings that a company has retained since inception - hence the name "retained earnings." The tricky part about this account is that it is cumulative. In order to calculate Retained Earnings (RE) correctly, you must do it from the start.
Let's think about how to calculate RE. The first question is, "What is earnings?" Most would agree that earnings can be calculated as Revenues - Expenses. The Income Statement labels that number as "Net Income," so we'll refer to earnings as Net Income (NI).
The next question is, "How does a company retain earnings?" It's actually easier to address how a company does not retain earnings, and that is by paying dividends. When a company pays a dividend, then it is distributing part of its earnings out to its shareholders, who receive them. Therefore, the part NOT paid in dividends is the part of earnings that is retained. We'll call dividends "Div."
So, then we have a formula:
Retained Earnings = Net Income - Dividends
RE = NI - Div
RE = NI - Div
(The second equation is the same as the first, but in the shorthand I noted above.) This is the exact formula that is calculated on the Income Statement, Line 53 (in the template I'm using).
The problem is that this RE is not equal to the RE on the Balance Sheet. The RE on the income statement represents the CHANGE in RE for this period on the Balance Sheet. Here's an example:
April 2008: Retained Earnings is calculated to be L$1,200
May 2008:
- Company has NI = L$1,500 and pays Div = L$1,000
- RE on the Income Statement is calculated as NI - Div = L$1,500 - L$1,000 = L$500
- RE on the Balance Sheet is calculated as RE(old) + RE(new) = L$1,200 + L$500 = L$1,700.
RE(t) = RE(t-1) + NI(t) - Div(t)
In words: Retained Earnings this period equal Retained Earnings last period plus net income this period minus dividends this period.
I hope that clears up some of the mystery with this line on the Balance Sheet. I see a lot of companies with incorrectly calculated RE, and it's really a pretty simple line to do. If you have any questions, feel free to leave a comment - anyone can.
Saturday, August 2, 2008
Where to Go?
Let's face it. Volumes on SL Capital Exchanges (all of them) are dismal, and liquidity is a major concern for investors. "Why should I plunk down several thousand of my hard-earn Linden Dollars if it'll take me months just to sell at a break-even price, and that's if I'm lucky?" With liquidity locked up, major investors will have a hard time realizing a profit on their investments, even if the market values of the particular stocks rise. So how do we fix this?
It seems that whenever a SL company goes belly-up, the CEO simply throws their hands in the air and walks away. That's because it's a possibility in Second Life. There is no chain connecting the CEO to the viewer which makes him or her responsible. Threats of legal action are simply idle talk, as even recovering something like $20,000 USD (about L$5.4 million) would be silly in the context of lawyers' and courts' fees (not to mention your time) to get it.
Certain exchanges have made progress in the realm of removing the complete anonymity of CEOs by requesting IDs for IPO clearance. Nevertheless, even if you know their ID, what good does it do you? Again, legal fees are too prohibitive.
I hesitate to say it, but I think it may be time to tie some more legal strings around the CEOs of SL companies. Some have suggested using promissory notes, but it sounds more like a fidelity bond issue to me, if there was an insurer who would ever cover it. The point remains the same, though: sending a message to CEOs that this is more than a game (in spite of the hypocritical boilerplate language at most exchanges), it is a responsibility which will reach out and slap you in real life if needed.
Before I let this tirade go too far, I do realize that this is not always something that a CEO wants to take on. I daresay that the salaries earned by most SL CEOs are nowhere near enough to compensate for the trouble which these legal ties could cause in real life. Maybe that's the answer, but I hope not.
I'd love to know how to restore investor confidence, but I'm just not seeing a way of doing it without giving investors some sort of recourse for CEO inadequacy or fraudulant activity.
Anyone else have other ideas? Comments?
It seems that whenever a SL company goes belly-up, the CEO simply throws their hands in the air and walks away. That's because it's a possibility in Second Life. There is no chain connecting the CEO to the viewer which makes him or her responsible. Threats of legal action are simply idle talk, as even recovering something like $20,000 USD (about L$5.4 million) would be silly in the context of lawyers' and courts' fees (not to mention your time) to get it.
Certain exchanges have made progress in the realm of removing the complete anonymity of CEOs by requesting IDs for IPO clearance. Nevertheless, even if you know their ID, what good does it do you? Again, legal fees are too prohibitive.
I hesitate to say it, but I think it may be time to tie some more legal strings around the CEOs of SL companies. Some have suggested using promissory notes, but it sounds more like a fidelity bond issue to me, if there was an insurer who would ever cover it. The point remains the same, though: sending a message to CEOs that this is more than a game (in spite of the hypocritical boilerplate language at most exchanges), it is a responsibility which will reach out and slap you in real life if needed.
Before I let this tirade go too far, I do realize that this is not always something that a CEO wants to take on. I daresay that the salaries earned by most SL CEOs are nowhere near enough to compensate for the trouble which these legal ties could cause in real life. Maybe that's the answer, but I hope not.
I'd love to know how to restore investor confidence, but I'm just not seeing a way of doing it without giving investors some sort of recourse for CEO inadequacy or fraudulant activity.
Anyone else have other ideas? Comments?
Saturday, July 26, 2008
It's been awhile...
So, it turns out I've been pretty bad at posting over the last few months. I've had things to keep me busy: one of my actuarial exams, work, RL moving, vacation, getting engaged, etc., so it's not like I'm short on excuses. Nevertheless, I think I should try to post and keep updating this thing periodically.
It seems like interest has waned in the market. I'm not entirely surprised, as most of the markets are rocked by scandal after scandal. New money coming in is kind of rare, as it seems that those who are involved with the markets currently are the only ones who would like to be involved. The lack of liquidity also frightens new investors, as the market value of securities is significantly more than the liquidation value (that is, if you sold all your shares as fast as you could) for almost every security, and even for modest amounts of shares.
For example, take SLR, the company I'm CFO for. (This is in no way a critique of my shareholders, but if I'm going to pick on a company, I might as well hit home.) Suppose I owned 10,000 shares of SLR right now. The market price shown on CapEx is L$6,500. However, if I actually tried to sell all 10,000 shares, I would receive (after commission) L$5,153.02, which is 79.3% of the displayed price. Make it 50,000 shares and I would only receive 12.9% of my displayed market value!!! And we're not talking vast sums of money here - 50,000 SLR shares at market is worth about $120 USD. Enough to care, but not enough to break most of us financially.
You can play this game with almost any stock on any market. There are exceptions, where management has taken care to set aside cash reserves to prevent this from happening, but by and large putting money into the market means you will need to take your time getting money out of the market.
I've heard the idea of market makers being tossed around before. For those of you who don't know, a market maker is a person/firm that makes money off the bid-ask spread in the market. They provide liquidity. However, from my previous actuarial exam (which I passed, by the way!), Modeling Financial Economics, market makers need options in order to protect themselves. There are techniques whereby market makers can insure themselves against large price changes, or even set themselves up to make money if the market doesn't move. However, these require options, which no exchange in SL has been willing to set up yet.
If any exchange in SL is seriously interested in setting up options and market making and similar techniques, please contact me. While I'm sure I'm not the only person in SL who understands how to make it work, I'm likely one of the few, and I would love to help.
I suppose the question is this: How do we revitalize the markets now? I think liquidity is the major issue, but I would like to hear what others think as well.
It seems like interest has waned in the market. I'm not entirely surprised, as most of the markets are rocked by scandal after scandal. New money coming in is kind of rare, as it seems that those who are involved with the markets currently are the only ones who would like to be involved. The lack of liquidity also frightens new investors, as the market value of securities is significantly more than the liquidation value (that is, if you sold all your shares as fast as you could) for almost every security, and even for modest amounts of shares.
For example, take SLR, the company I'm CFO for. (This is in no way a critique of my shareholders, but if I'm going to pick on a company, I might as well hit home.) Suppose I owned 10,000 shares of SLR right now. The market price shown on CapEx is L$6,500. However, if I actually tried to sell all 10,000 shares, I would receive (after commission) L$5,153.02, which is 79.3% of the displayed price. Make it 50,000 shares and I would only receive 12.9% of my displayed market value!!! And we're not talking vast sums of money here - 50,000 SLR shares at market is worth about $120 USD. Enough to care, but not enough to break most of us financially.
You can play this game with almost any stock on any market. There are exceptions, where management has taken care to set aside cash reserves to prevent this from happening, but by and large putting money into the market means you will need to take your time getting money out of the market.
I've heard the idea of market makers being tossed around before. For those of you who don't know, a market maker is a person/firm that makes money off the bid-ask spread in the market. They provide liquidity. However, from my previous actuarial exam (which I passed, by the way!), Modeling Financial Economics, market makers need options in order to protect themselves. There are techniques whereby market makers can insure themselves against large price changes, or even set themselves up to make money if the market doesn't move. However, these require options, which no exchange in SL has been willing to set up yet.
I suppose the question is this: How do we revitalize the markets now? I think liquidity is the major issue, but I would like to hear what others think as well.
Tuesday, June 10, 2008
Benevolent dictatorship
Noun: A dictatorship in which the leader has power only because the people choose to allow them to remain. This necessitates a wise use of power and generally prevents abuses since the benevolent dictator loses power if they are unsuitable. (From the Wiktionary)
Why this post? There is currently some debate going on here at Your2ndPlace and at the International Stock Exchange.
The debate seems to be "Bottom-Top Vs. Top-Bottom" management/regulation and according to someone the VSTEX has moved from the first to the second stance, effectively aligning with the WSE.
This post will be probably disappoint someone. It won't be a deep analysis of the pros and cons of both stances. Here I won't be trying to change anyone's mind. People have been arguing on issues since the human race was born. They'll still do after this post of mine.
First off, to me financial markets on Second Life could be related to the situation in the US before the Securities Act of 1933. You can translate that into "an unregulated situation" if you like. Since that Act, more steps were taken but we won't go over the whole process now.
Let's just say that in SL we lack a lot of things (when it comes to policies, regulations, governing bodies and applicable laws) that we can have in "real life".
When the VSTEX was started there was an optimistic view of a community wanting and willing to work together, in order to build a lively virtual stock exchange. That was the philosophy before I joined the VSTEX (which happened a few later of it going public) and I must admit I quite liked it.
It did not work that way though. Now one may say that we just changed our mind, that we woke up one day saying "To the hell with shareholders, we'll do what we want and so be it".
Over the time we found out (the hard way) that exchange users were of 2 kinds: educated and uneducated (with the latter group being apparently the majority). Educated users know what they do, they often know how to game the system, sometimes they are not so well intentioned and they may resort to practices that would be frowned upon in the real world (when those practices are not outright illegal).
Of course there is nothing wrong with educated users per se, on our exchange there is plenty of well intentioned, honest, educated users.
Maybe we failed to create the conditions to develop a thriving community capable of setting standards and rules. That's a possibility. At the beginning we were too new to have a significant amount of honest, well educated users. There were the WSE, the SLCAPEX, the ISE. Extablished, bigger markets.
It didn't take much time before we had to face the Jasper Tizzy issue. Everyone who's been following SL financial news for a while should know about it. That led us to the conclusion that extra steps had to be taken, steps that the community wasn't still asking for. Almost all the requests we got at that time were along the lines of "Where's my money, I want my money, give me back my money".
Following that, we had to take a decision (someone here may argue "You really had to?" to which I would answer "Hell, yes") because we really did not like the "The CEO has fled, there's no money left, the company is delisted. Have a nice day." attitude that was standard for other exchanges I believe, before WSE's WTF (World Traders Fund) was born.
That decision was, to look for someone willing to take over the company (actually, the name and the listing with us since no money was left behind by the old CEO), trying to revive it and turn disgruntled shareholders into happy ones. At that time we did not realize it, but it was the first step for top-bottom management and regulation. Nobody ever asked for that (maybe because it was so unusual?), yet we did it. In the aftermath of the AVC history, I can tell we opened a canning of worms. However, I don't regret that decision. None of us VSTEX managers does.
Since then there have been issues with other companies and while the rules we've been adding have been implemented without directly asking the investors or running polls, the investors (of course, some of them) themselves have been asking us via emails and support tickets to build up our rules and make our control on listed companies more tight.
I'll quote Konner McDonnell:
"Evolving. Changing. Remembering. Like I expect all virtual exchanges SHOULD."
And Cocky Dagger:
"Sometimes issues can be more complicated than they appear and I would say the obvious choice is not always the best choice. I actually started out early on with one belief and time and experience has caused me to do a 180 from where I was at."
We reckon that some sections of our website should be updated and that we may want to rethink our strategies and goals. I could go on for miles here, however I'll cut it short here. I'll just invite everyone to our General Discussion forum (a VSTEX account is needed to login update: now everyone can browse our forums). We're always open to discussion.
Why this post? There is currently some debate going on here at Your2ndPlace and at the International Stock Exchange.
The debate seems to be "Bottom-Top Vs. Top-Bottom" management/regulation and according to someone the VSTEX has moved from the first to the second stance, effectively aligning with the WSE.
This post will be probably disappoint someone. It won't be a deep analysis of the pros and cons of both stances. Here I won't be trying to change anyone's mind. People have been arguing on issues since the human race was born. They'll still do after this post of mine.
First off, to me financial markets on Second Life could be related to the situation in the US before the Securities Act of 1933. You can translate that into "an unregulated situation" if you like. Since that Act, more steps were taken but we won't go over the whole process now.
Let's just say that in SL we lack a lot of things (when it comes to policies, regulations, governing bodies and applicable laws) that we can have in "real life".
When the VSTEX was started there was an optimistic view of a community wanting and willing to work together, in order to build a lively virtual stock exchange. That was the philosophy before I joined the VSTEX (which happened a few later of it going public) and I must admit I quite liked it.
It did not work that way though. Now one may say that we just changed our mind, that we woke up one day saying "To the hell with shareholders, we'll do what we want and so be it".
Over the time we found out (the hard way) that exchange users were of 2 kinds: educated and uneducated (with the latter group being apparently the majority). Educated users know what they do, they often know how to game the system, sometimes they are not so well intentioned and they may resort to practices that would be frowned upon in the real world (when those practices are not outright illegal).
Of course there is nothing wrong with educated users per se, on our exchange there is plenty of well intentioned, honest, educated users.
Maybe we failed to create the conditions to develop a thriving community capable of setting standards and rules. That's a possibility. At the beginning we were too new to have a significant amount of honest, well educated users. There were the WSE, the SLCAPEX, the ISE. Extablished, bigger markets.
It didn't take much time before we had to face the Jasper Tizzy issue. Everyone who's been following SL financial news for a while should know about it. That led us to the conclusion that extra steps had to be taken, steps that the community wasn't still asking for. Almost all the requests we got at that time were along the lines of "Where's my money, I want my money, give me back my money".
Following that, we had to take a decision (someone here may argue "You really had to?" to which I would answer "Hell, yes") because we really did not like the "The CEO has fled, there's no money left, the company is delisted. Have a nice day." attitude that was standard for other exchanges I believe, before WSE's WTF (World Traders Fund) was born.
That decision was, to look for someone willing to take over the company (actually, the name and the listing with us since no money was left behind by the old CEO), trying to revive it and turn disgruntled shareholders into happy ones. At that time we did not realize it, but it was the first step for top-bottom management and regulation. Nobody ever asked for that (maybe because it was so unusual?), yet we did it. In the aftermath of the AVC history, I can tell we opened a canning of worms. However, I don't regret that decision. None of us VSTEX managers does.
Since then there have been issues with other companies and while the rules we've been adding have been implemented without directly asking the investors or running polls, the investors (of course, some of them) themselves have been asking us via emails and support tickets to build up our rules and make our control on listed companies more tight.
I'll quote Konner McDonnell:
"Evolving. Changing. Remembering. Like I expect all virtual exchanges SHOULD."
And Cocky Dagger:
"Sometimes issues can be more complicated than they appear and I would say the obvious choice is not always the best choice. I actually started out early on with one belief and time and experience has caused me to do a 180 from where I was at."
We reckon that some sections of our website should be updated and that we may want to rethink our strategies and goals. I could go on for miles here, however I'll cut it short here. I'll just invite everyone to our General Discussion forum (a VSTEX account is needed to login update: now everyone can browse our forums). We're always open to discussion.
Saturday, May 17, 2008
Options: Lesson 2
Guardian's Note: This is a continuation (though much overdue) of a previous post which I wrote awhile ago. Reading that post will likely be necessary for a good understanding of this one.
Now that you have a good intuitive understanding of what a call and put option on a stock are, and how to use them, let's think about how to price them.
When building a model for options pricing, there tend to be a set of convenient assumptions made to simplify the process. First, there are no transaction costs or taxes. Secondly, you can buy or sell as much of any stock/option without altering the price. Thirdly, volatility (we'll get to that later) will be known and constant. I think that's all I'll need for this lesson.
Certainly, the value of the option is determined by the value of the stock at some given point in time. If the option is European, then the only relevant value is the price at the end of the time period.
Suppose we have a stock at price S0 currently, and there is a European call option expiring at time 1 with strike price K = S0. Now, in this particular oversimplified world, the stock can only take on two values at time 1: Su and Sd, standing for an "up" movement and a "down" movement. Since the option is at strike K = S0, the option will pay (Su - S0) at Su and zero at Sd. We'll denote these values by Cu and Cd respectively (representing the value of the call at an up movement and the value of the call at a down movement).
The price of the option can then be calculated as
Where v is the present value factor to discount the payoff with interest back to time zero. We'll need an interest rate to do that, which we'll call r. We'll also need P(up movement) (the probability of an up movement) to calculate the price.
Through some mathemagic which I think I'll gloss over for now (but if you all want to see it, I'll happily spell it out), a probability which correctly calculates the price can be found using this formula:
Where r is the continuously compounded rate of return, d is the continuously compounded rate of dividend payments, h is the time period (in years), d is the multiplicative factor by which S can decrease over h, and u is the multiplicative factor by which S can increase over h.
There are also formulas for u and d, but if you need those I suggest reading this.
With all of that in place, there is now a formula for pricing a call option where the stock has only two movements, up or down. This model can be expanded to include more periods, use discrete dividends (say the stock pays $10 at time 0.75), handle American options, and do a variety of other nice tricks. However, the more important fact is that this is the backbone of the famed Black and Scholes model, which I will discuss in Lesson 3.
I hope you can see how this all gets very hairy mathematically very quickly. Some of the background I jumped over is done not by mathematical proof, but by economic logic, which may not sit well with some mathematicians. I have also tried to simplify a lot of this to be read by the general audience, whereas for the last four months I've been studying the specifics of this, and more complex models, extensively. If any of you readers are curious about this topic on a deeper level, feel free to post here, IM me in world, or email me at guardian.market@gmail.com. I can't guarantee I'll know the answer (it's a big world out there with options!) but I'll try to at least point you in the right direction.
Now that you have a good intuitive understanding of what a call and put option on a stock are, and how to use them, let's think about how to price them.
When building a model for options pricing, there tend to be a set of convenient assumptions made to simplify the process. First, there are no transaction costs or taxes. Secondly, you can buy or sell as much of any stock/option without altering the price. Thirdly, volatility (we'll get to that later) will be known and constant. I think that's all I'll need for this lesson.
Certainly, the value of the option is determined by the value of the stock at some given point in time. If the option is European, then the only relevant value is the price at the end of the time period.
Suppose we have a stock at price S0 currently, and there is a European call option expiring at time 1 with strike price K = S0. Now, in this particular oversimplified world, the stock can only take on two values at time 1: Su and Sd, standing for an "up" movement and a "down" movement. Since the option is at strike K = S0, the option will pay (Su - S0) at Su and zero at Sd. We'll denote these values by Cu and Cd respectively (representing the value of the call at an up movement and the value of the call at a down movement).
The price of the option can then be calculated as
Cu * P(up movement) * v
Where v is the present value factor to discount the payoff with interest back to time zero. We'll need an interest rate to do that, which we'll call r. We'll also need P(up movement) (the probability of an up movement) to calculate the price.
Through some mathemagic which I think I'll gloss over for now (but if you all want to see it, I'll happily spell it out), a probability which correctly calculates the price can be found using this formula:
P(up movement) = (e(r-d)*h-d)/(u-d)
Where r is the continuously compounded rate of return, d is the continuously compounded rate of dividend payments, h is the time period (in years), d is the multiplicative factor by which S can decrease over h, and u is the multiplicative factor by which S can increase over h.
There are also formulas for u and d, but if you need those I suggest reading this.
With all of that in place, there is now a formula for pricing a call option where the stock has only two movements, up or down. This model can be expanded to include more periods, use discrete dividends (say the stock pays $10 at time 0.75), handle American options, and do a variety of other nice tricks. However, the more important fact is that this is the backbone of the famed Black and Scholes model, which I will discuss in Lesson 3.
I hope you can see how this all gets very hairy mathematically very quickly. Some of the background I jumped over is done not by mathematical proof, but by economic logic, which may not sit well with some mathematicians. I have also tried to simplify a lot of this to be read by the general audience, whereas for the last four months I've been studying the specifics of this, and more complex models, extensively. If any of you readers are curious about this topic on a deeper level, feel free to post here, IM me in world, or email me at guardian.market@gmail.com. I can't guarantee I'll know the answer (it's a big world out there with options!) but I'll try to at least point you in the right direction.
Friday, May 2, 2008
My Lack of Posting
...has been due to studying for my next actuarial exam, Exam MFE (scroll down a little to the Financial Economics segment).
I'll be more active after the 15th.
My apologies for the lack of mathematical reading.
I'll be more active after the 15th.
My apologies for the lack of mathematical reading.
Wednesday, April 9, 2008
Mathematical Evangalism: The Monty Hall Problem
Every once in awhile, I have to go on a streak of public education for the betterment of society. The Monty Hall problem presents such an opportunity and just cause for such evangelism, as this non-intuitive probability problem routinely trips up even sharp-minded folk. So, I present to you a problem:
Suppose you're on a game show. You've made it to the final round, and there are three doors presented. Two of the doors have a goat behind them, meaning you win nothing, and the third holds a new car. Choose the door with the car, and you win that. You make your choice, and before revealing your choice, your host (Monty Hall, hence the name) opens one of the remaining two doors to reveal a goat. He then asks you if you'd like to switch. Is it advantageous to switch doors? What is your probability of winning if you do/do not switch?
...think about it...
...got an answer in mind yet?
The surprising answer is that switching gives you a 2/3 chance of winning. Most people guess 1/2 - there are two doors remaining, and one of them is right. However, let's think of this differently.
When you first choose, you have a 1/3 chance of getting the right door. Then, an incorrect door is revealed. If you were originally right and you switch, you're now wrong. But if you were originally wrong and you now switch, you're right. Because you had an initial chance of 2/3 of being wrong, by switching you now have a 2/3 chance of being right, hence the answer.
Don't believe me? Play a few rounds online and convince yourself.
Suppose you're on a game show. You've made it to the final round, and there are three doors presented. Two of the doors have a goat behind them, meaning you win nothing, and the third holds a new car. Choose the door with the car, and you win that. You make your choice, and before revealing your choice, your host (Monty Hall, hence the name) opens one of the remaining two doors to reveal a goat. He then asks you if you'd like to switch. Is it advantageous to switch doors? What is your probability of winning if you do/do not switch?
...think about it...
...got an answer in mind yet?
The surprising answer is that switching gives you a 2/3 chance of winning. Most people guess 1/2 - there are two doors remaining, and one of them is right. However, let's think of this differently.
When you first choose, you have a 1/3 chance of getting the right door. Then, an incorrect door is revealed. If you were originally right and you switch, you're now wrong. But if you were originally wrong and you now switch, you're right. Because you had an initial chance of 2/3 of being wrong, by switching you now have a 2/3 chance of being right, hence the answer.
Don't believe me? Play a few rounds online and convince yourself.
Tuesday, April 8, 2008
Land Prices
Linden Labs announced recently that it would be dropping prices of land sales significantly. New islands, for example, will only cost USD$1,000, down from USD$1,675 as last I recall.
Talk about a way to piss off your most loyal supporters! Everyone currently holding land just took a major hit to their resale value, and my understanding was that land prices had been dropping anyway. While this will certainly encourage new growth, I think there will be a painful period of losses for existing (especially startup) businesses as well. As the new land is sold, those owners can price their rents lower and simply outbid the current ones still paying off their $1,675.
Linden Labs is obviously placing a bet on the elasticity of demand for land. Elasticity, for the uninitiated, is how much the quantity demanded of a good changes with respect to a price change. Some goods, like (some) electronics, are very elastic - small drops in price will produce large sales and vice versa. Other goods, like salt, aren't elastic at all ("inelastic") - you can double the price of salt, and people will still buy about as much as they did before. A few very rare goods, like gasoline, are inelastic in the short run and elastic in the long run...but I'm getting off-topic...
If the demand for new land is elastic, LL will see a large jump in sales for their drop in price. My guess is they're hoping this outweights (a) the amount of anger they're generating, and (b) the amount of extremists who go researching into OpenSim projects.
Let's see how the bet pays off.
Talk about a way to piss off your most loyal supporters! Everyone currently holding land just took a major hit to their resale value, and my understanding was that land prices had been dropping anyway. While this will certainly encourage new growth, I think there will be a painful period of losses for existing (especially startup) businesses as well. As the new land is sold, those owners can price their rents lower and simply outbid the current ones still paying off their $1,675.
Linden Labs is obviously placing a bet on the elasticity of demand for land. Elasticity, for the uninitiated, is how much the quantity demanded of a good changes with respect to a price change. Some goods, like (some) electronics, are very elastic - small drops in price will produce large sales and vice versa. Other goods, like salt, aren't elastic at all ("inelastic") - you can double the price of salt, and people will still buy about as much as they did before. A few very rare goods, like gasoline, are inelastic in the short run and elastic in the long run...but I'm getting off-topic...
If the demand for new land is elastic, LL will see a large jump in sales for their drop in price. My guess is they're hoping this outweights (a) the amount of anger they're generating, and (b) the amount of extremists who go researching into OpenSim projects.
Let's see how the bet pays off.
Monday, March 24, 2008
A Balance Sheet in Motion
By popular demand (both of you), I am going to do an elongated article on balance sheets, what they measure, and perhaps more importantly for my readers, how they change. This article will be pretty basic, and isn't likely to solve your specific reporting needs, but hopefully will give you a better understanding of how these crazy financial templates are supposed to work.
The first question I had when I heard the name "Balance Sheet" was, "well, what does it balance?" The answer is that it is a demonstration the accounting equation is in balance, hence the name. This all-important accounting equation is highly important, and is written as:
Every transaction that a business does affects this equation. Let me go through a few examples. In each of these cases, the amount of the transaction is not important, and so will be represented by x.
Case 1: You spend money on land
Land is an asset. Cash is an asset. Therefore, the equation changes by
Case 2: You take out a loan to buy land
Land is an asset. A loan is a liability.
Case 3: You sell some stock for cash.
Cash is an asset. Stock is an equity.
You'll notice that in all of these cases, the balance equation doesn't change. The x's always cancel out. This is important, because it keeps the equation in balance. The equation should never be out of balance - it indicates an error. This is one of the fastest ways to show if someone knows what they're doing with a balance sheet - if it doesn't balance, it's clearly wrong.
So, you might ask, if the balance equation never changes, how do I show that my business is growing or (hopefully not) shrinking? The answer comes with Retained Earnings (RE). Retained Earnings is an equity account and is basically equal to Net Income - Dividends Paid. Say, for example, that you make some profits and receive them in cash. Your balance equation changes by
You'll notice that even though the entire equation grew by x, the equation is still in balance.
The balance sheet shows the composition of your company, and RE is the mechanism through which the whole company grows or shrinks. There are other accounts which can do this as well, but RE is by far the most common.
I thought it might be instructive to give a series of examples of how a balance sheet for a fictional company might change over time. Therefore, I've developed a Google Document with different tabs, each tab showing a different step in this company's development. At each step, I will only list non-zero accounts, and will provide a proof that the balance equation is working. As a commentary, I'll also post step-by-step comments here that you can read along.
Spreadsheet Link
The first step is boring. A new company is born! However, this company is nothing more than an idea.
All accounts are zero, and the equation is an exciting 0 = 0 + 0. At least it works.
Step 2: The company issues 1,000,000 shares of stock and gets L$1,000,000 cash.
Equities increase and cash increases. Note that I'm not messing with Par Value for this example.
Step 3: The company buys a small plot of land for L$100,000 and builds a store on it for L$50,000.
Plant, Property, and Equipment is the store, but they had to pay cash for it so this decreases.
Step 4: The company pays a designer L$30,000 cash for the right to sell their designs in the store.
Since the company now has some inventory to sell, the company needs to record the cost of this inventory. Notice that inventory is not equal to the potential revenue from this product, but rather the cost in obtaining it.
Step 5: The company meets another designer and wants to buy their design for L$20,000. However, the company decides to wait and pay this designer at some point later, instead of right now. The designer is OK with this and gives the company the designs.
Now the company has a liability, called "Accounts Payable" because they will at some point have to pay this new designer. However, they also got inventory to sell in exchange for taking on this liability. Notice that this is the first point in this exercise where the company has actually changed value from their original L$1,000,000. This is because they are leveraging themselves using debt, which will eventually need to be paid back with another asset (probably cash). When this happens, the liability will disappear, along with the corresponding amount of cash to go with it.
Step 6: The company spends L$100,000 advertising their wonderful new business.
Marketing is not an asset. It is temporary, and thus is recorded on the income statement. However, we lost cash, and so we still have to make the balance equation work. In order to do this, imagine an income statement with just one entry on it: marketing expense of L$100,000. This would carry down through to net income, where it would then go to Retained Earnings! That's what's happening here. Because I'm doing this step-by-step this may seem a little strange, but this is what happens every day in business. It's just that the reporting periods clump groups of transactions into time periods, which are easier to understand.
Step 7: The company's advertising pays off! They get L$200,000 worth of sales!
Now Retained Earnings will increase by the revenue they received. Cash will also increase to balance this out.
Step 8: The company decides to pay off that second designer, now they they've sold some of his designs. They send him L$20,000.
Now the liability will go away and cash will decrease.
Step 9: The company issues a dividend for L$50,000 to its shareholders.
Dividends come out of Retained Earnings. The formula for RE is actually
Cash decreases, and so does RE.
Step 10: The company pays L$10,000 worth of tier payments on their land.
This costs cash, and tier payments are on the income statement, meaning they will come out of retained earnings. Therefore, cash and RE both decrease.
Notice how at every transaction, the balance equation is kept in balance. This is demonstrated on every step throughout this elongated example. If at any point the equation is out of balance, something funny is going on or a transaction hasn't been recorded properly, and so it's time to examine the process.
Now I know it's not practical to keep a running balance sheet for most SL businesses. However, I think that most CEOs should at least be aware of how the transactions they're doing affect the balance sheet.
I also know that there are a myriad of topics and situations I have not covered here. Some of these topics get rather involved and can have different meanings depending on what the management is intending. A great example of this is buying back stock. Although it's easy to see that cash decreases, what happens to balance it? Equities should decrease, but how? That's a tricky topic, one which I don't want to touch here.
And now, a word about my accounting partnership:
SLFR Group does not (in my mind) exist to force people who have the unfortunate circumstance of not understanding financial statements into paying for them. Rather, it is to aid in the preparation of these statements and to serve as a check for those who are unsure of their own abilities. I'm here to help, not harm.
iVentures (my partner in SLFR Group) and I are both familiar with the exchange reporting standards and would be happy to assist you in preparing your company's statements.
The first question I had when I heard the name "Balance Sheet" was, "well, what does it balance?" The answer is that it is a demonstration the accounting equation is in balance, hence the name. This all-important accounting equation is highly important, and is written as:
Assets = Liabilities + Equity
Every transaction that a business does affects this equation. Let me go through a few examples. In each of these cases, the amount of the transaction is not important, and so will be represented by x.
Case 1: You spend money on land
Land is an asset. Cash is an asset. Therefore, the equation changes by
Assets - x + x = Liabilities + Equity
Case 2: You take out a loan to buy land
Land is an asset. A loan is a liability.
Assets + x = Liabilities + x + Equity
Case 3: You sell some stock for cash.
Cash is an asset. Stock is an equity.
Assets + x = Liabilities + Equity + x
You'll notice that in all of these cases, the balance equation doesn't change. The x's always cancel out. This is important, because it keeps the equation in balance. The equation should never be out of balance - it indicates an error. This is one of the fastest ways to show if someone knows what they're doing with a balance sheet - if it doesn't balance, it's clearly wrong.
So, you might ask, if the balance equation never changes, how do I show that my business is growing or (hopefully not) shrinking? The answer comes with Retained Earnings (RE). Retained Earnings is an equity account and is basically equal to Net Income - Dividends Paid. Say, for example, that you make some profits and receive them in cash. Your balance equation changes by
Assets + x = Liabilities + Equity + x
You'll notice that even though the entire equation grew by x, the equation is still in balance.
The balance sheet shows the composition of your company, and RE is the mechanism through which the whole company grows or shrinks. There are other accounts which can do this as well, but RE is by far the most common.
I thought it might be instructive to give a series of examples of how a balance sheet for a fictional company might change over time. Therefore, I've developed a Google Document with different tabs, each tab showing a different step in this company's development. At each step, I will only list non-zero accounts, and will provide a proof that the balance equation is working. As a commentary, I'll also post step-by-step comments here that you can read along.
Spreadsheet Link
The first step is boring. A new company is born! However, this company is nothing more than an idea.
All accounts are zero, and the equation is an exciting 0 = 0 + 0. At least it works.
Step 2: The company issues 1,000,000 shares of stock and gets L$1,000,000 cash.
Equities increase and cash increases. Note that I'm not messing with Par Value for this example.
Step 3: The company buys a small plot of land for L$100,000 and builds a store on it for L$50,000.
Plant, Property, and Equipment is the store, but they had to pay cash for it so this decreases.
Step 4: The company pays a designer L$30,000 cash for the right to sell their designs in the store.
Since the company now has some inventory to sell, the company needs to record the cost of this inventory. Notice that inventory is not equal to the potential revenue from this product, but rather the cost in obtaining it.
Step 5: The company meets another designer and wants to buy their design for L$20,000. However, the company decides to wait and pay this designer at some point later, instead of right now. The designer is OK with this and gives the company the designs.
Now the company has a liability, called "Accounts Payable" because they will at some point have to pay this new designer. However, they also got inventory to sell in exchange for taking on this liability. Notice that this is the first point in this exercise where the company has actually changed value from their original L$1,000,000. This is because they are leveraging themselves using debt, which will eventually need to be paid back with another asset (probably cash). When this happens, the liability will disappear, along with the corresponding amount of cash to go with it.
Step 6: The company spends L$100,000 advertising their wonderful new business.
Marketing is not an asset. It is temporary, and thus is recorded on the income statement. However, we lost cash, and so we still have to make the balance equation work. In order to do this, imagine an income statement with just one entry on it: marketing expense of L$100,000. This would carry down through to net income, where it would then go to Retained Earnings! That's what's happening here. Because I'm doing this step-by-step this may seem a little strange, but this is what happens every day in business. It's just that the reporting periods clump groups of transactions into time periods, which are easier to understand.
Step 7: The company's advertising pays off! They get L$200,000 worth of sales!
Now Retained Earnings will increase by the revenue they received. Cash will also increase to balance this out.
Step 8: The company decides to pay off that second designer, now they they've sold some of his designs. They send him L$20,000.
Now the liability will go away and cash will decrease.
Step 9: The company issues a dividend for L$50,000 to its shareholders.
Dividends come out of Retained Earnings. The formula for RE is actually
Old Retained Earnings + Net Income - Dividends = New Retained Earnings
Cash decreases, and so does RE.
Step 10: The company pays L$10,000 worth of tier payments on their land.
This costs cash, and tier payments are on the income statement, meaning they will come out of retained earnings. Therefore, cash and RE both decrease.
Notice how at every transaction, the balance equation is kept in balance. This is demonstrated on every step throughout this elongated example. If at any point the equation is out of balance, something funny is going on or a transaction hasn't been recorded properly, and so it's time to examine the process.
Now I know it's not practical to keep a running balance sheet for most SL businesses. However, I think that most CEOs should at least be aware of how the transactions they're doing affect the balance sheet.
I also know that there are a myriad of topics and situations I have not covered here. Some of these topics get rather involved and can have different meanings depending on what the management is intending. A great example of this is buying back stock. Although it's easy to see that cash decreases, what happens to balance it? Equities should decrease, but how? That's a tricky topic, one which I don't want to touch here.
And now, a word about my accounting partnership:
SLFR Group does not (in my mind) exist to force people who have the unfortunate circumstance of not understanding financial statements into paying for them. Rather, it is to aid in the preparation of these statements and to serve as a check for those who are unsure of their own abilities. I'm here to help, not harm.
iVentures (my partner in SLFR Group) and I are both familiar with the exchange reporting standards and would be happy to assist you in preparing your company's statements.
Friday, March 14, 2008
Options: Lesson 1
One of my favorite topics in finance is that of options. I've mentioned options in a few previous posts, and I would like to dedicate a few posts to the mechanics of options and option pricing. Coincidentally, this is also the same material that I'm studying for my next RL actuarial exam, exam MFE (Modeling: Financial Economics).
Options are power. There are no markets in Second Life that trade options. Some are afraid investors will use them without understanding them. Others are swamped fixing other bugs so that the thought of including derivatives is nearly impossible at present. Regardless, options exist in real life, and they're useful in real life. Whether they ever exist in SL, these lessons will teach you about what options are, how they operate, and how to price them (at least basically). I'll be using some mathematics for this, and the lessons will build on each other.
For our purposes, we will concentrate on options on an underlying stock. However, you should know that options also exist on futures, currencies, indexes, and even other options. Each of these brings a new caveat to the stage, but for my sanity I'm going to stick to cash and stocks.
There are two broad types of options. I'm going to go over them very slowly:
A call option gives the owner the right, but not the obligation, to buy an underlying stock at a specified strike price (K) by time T.
A put option gives the owner the right, but not the obligation, to sell an underlying stock at a specified strike price (K) by time T.
Read those two sentences again. And again. One more time.
Also know that I'm describing American options in the definitions above. If they were European options, they would have ended with "at time T" instead of "by time T." Some of the pricing models will only value European options, but I'll make sure to warn you ahead of time.
If the price of the underlying stock is denoted as S, then the payoff of the call option is
Call Payoff = Max{0,S-K}
This is because if the stock price (S) is below the strike price (K), then you simply choose not to exercise the option (why buy the stock at K when it's selling at S?). If S > K, though, you can buy at K and then sell at S, netting S-K for yourself. Similarly, the payoff for a put option is
Put Payoff = Max{0,K-S}
If the stock price (S) is below the strike price (K), then you can buy the stock at S and sell it at K, netting you K-S. If S > K, then you would prefer to sell at S, and so it is not advantageous to exercise your put option (and thus the value is zero).
Wikipedia has some nice graphs of a call payoff and put payoff, which I encourage you to look at.
That's it for lesson 1. Subsequent lessons will get into the pricing, and then the all-important parity equation and how that functions. More math coming, I promise!
Please, if you have questions, ASK! This material can be very confusing, even for advanced traders. I'm probably going to speed up, not slow down, in the next lesson, so get questions out of the way now. If you're too shy to post them here (even anonymously), then email me at guardian.market@gmail.com.
Options are power. There are no markets in Second Life that trade options. Some are afraid investors will use them without understanding them. Others are swamped fixing other bugs so that the thought of including derivatives is nearly impossible at present. Regardless, options exist in real life, and they're useful in real life. Whether they ever exist in SL, these lessons will teach you about what options are, how they operate, and how to price them (at least basically). I'll be using some mathematics for this, and the lessons will build on each other.
For our purposes, we will concentrate on options on an underlying stock. However, you should know that options also exist on futures, currencies, indexes, and even other options. Each of these brings a new caveat to the stage, but for my sanity I'm going to stick to cash and stocks.
There are two broad types of options. I'm going to go over them very slowly:
A call option gives the owner the right, but not the obligation, to buy an underlying stock at a specified strike price (K) by time T.
A put option gives the owner the right, but not the obligation, to sell an underlying stock at a specified strike price (K) by time T.
Read those two sentences again. And again. One more time.
Also know that I'm describing American options in the definitions above. If they were European options, they would have ended with "at time T" instead of "by time T." Some of the pricing models will only value European options, but I'll make sure to warn you ahead of time.
If the price of the underlying stock is denoted as S, then the payoff of the call option is
Call Payoff = Max{0,S-K}
This is because if the stock price (S) is below the strike price (K), then you simply choose not to exercise the option (why buy the stock at K when it's selling at S?). If S > K, though, you can buy at K and then sell at S, netting S-K for yourself. Similarly, the payoff for a put option is
Put Payoff = Max{0,K-S}
If the stock price (S) is below the strike price (K), then you can buy the stock at S and sell it at K, netting you K-S. If S > K, then you would prefer to sell at S, and so it is not advantageous to exercise your put option (and thus the value is zero).
That's it for lesson 1. Subsequent lessons will get into the pricing, and then the all-important parity equation and how that functions. More math coming, I promise!
Please, if you have questions, ASK! This material can be very confusing, even for advanced traders. I'm probably going to speed up, not slow down, in the next lesson, so get questions out of the way now. If you're too shy to post them here (even anonymously), then email me at guardian.market@gmail.com.
Tuesday, March 11, 2008
Distractions
Sorry I've been a little slow on posting this past week. I've been distracted by my RL work and the launching of an accounting firm partnership with iVentures Volitant. You can find that announcement here.
Saturday, March 1, 2008
Let the Games Begin!
With the WSE's announcement that it is leaving the Linden Dollar behind and going to trade solely in World Internet Currency units (WICs), the competition has begun for companies to be from the WSE to other exchanges. Already two have jumped ship: MAI and HOT, and one has sworn allegiance: DDE. As for the other side of the coin, to my knowledge two of the exchanges, VSTEX and CapEx are offering incentives for companies to switch. VSTEX is offering 10% off their IPO/relising fees, and CapEx is offering 100% off of them, both for a limited time.
It's an interesting battle, really. DDE's decision to stay surprised me greatly, as I would have thought that a business being conducted in Linden dollars, established in Linden dollars, and (until now) paying dividends until Linden dollars would have wanted to stay away from changing currencies and paying loads of transaction fees in order to bring any kind of value to their shareholders. But Delicious tends to know what she's doing, so maybe she's got something up her sleeve that I don't know about.
The question in my mind is how many of the WSE's 42 companies will jump ship in the next month. I really can't understand any retail or land company wanting to stay on the WSE now. Scripters and investment firms could still survive in WICs, since the scripters can simply request payment in USD and the investment firms should be savvy enough in whatever currency. I had originally thought the flight would be more severe, but so far it seems like companies are proceeding as normal, much to my surprise.
As to WSE 4.0 itself, I can only conclude that Luke Connell is attempting to reach outside the walls of Second Life, probably for at least two reasons. The first is that if he leaves Second Life and keeps the companies with him, he's outside the reach of Linden Lab's mighty ban hammer. The second reason is that he allows himself to list firms from other worlds, perhaps the Entropia Universe or IMVU. If it works, it could be amazing.
However, also I've got to wonder about the profitability of HCL at this point. We know HCL has defaulted twice on its bonds, and has had no income for 50-some days and counting. HCL owns an island with low occupancy, but tier still comes due, as well as a hefy (and ad-free, I believe) web server. According to the HCL income statements, HCL had L$8.3 million in profit (neglecting the L$2.78 million they owe in bond interest currently*) ending January 1, which is about USD$31,300. I'm not saying they're going bankrupt right away, but between all the expenses (who pays for Connell's RL expenses, anyway?) I've got to wonder if this conversion to WICs isn't just all smoke and mirrors to mitigate some deposit liabilities.
With no one demanding Linden dollars, who is to say what's happening to those dollars? While there may be an initial "dump the WICs" session, I imagine the WIC will be fairly illiquid. Some hefty transaction fees could make sure people keep their "game tokens" as WICs and not as Lindens, allowing Connell free use of all the Lindens deposited into the WSE.
But enough of the theories, I have a more important question to the CEOs of the WSE: Which of you will stand by a twice-defaulted exchange moving away from your primary transaction currency? Which of you will remain next to the CEO who has played a major role in the collapse of not one, but two of Second Life's major banking institutions? And how will you justify it to your investors?
*If anyone can explain to me how you can manage to post an L$8.3 million profit and yet not have L$2.8 million to pay your bondholders with, I'd love to hear that reasoning. Please include the mathematics behind it.
It's an interesting battle, really. DDE's decision to stay surprised me greatly, as I would have thought that a business being conducted in Linden dollars, established in Linden dollars, and (until now) paying dividends until Linden dollars would have wanted to stay away from changing currencies and paying loads of transaction fees in order to bring any kind of value to their shareholders. But Delicious tends to know what she's doing, so maybe she's got something up her sleeve that I don't know about.
The question in my mind is how many of the WSE's 42 companies will jump ship in the next month. I really can't understand any retail or land company wanting to stay on the WSE now. Scripters and investment firms could still survive in WICs, since the scripters can simply request payment in USD and the investment firms should be savvy enough in whatever currency. I had originally thought the flight would be more severe, but so far it seems like companies are proceeding as normal, much to my surprise.
As to WSE 4.0 itself, I can only conclude that Luke Connell is attempting to reach outside the walls of Second Life, probably for at least two reasons. The first is that if he leaves Second Life and keeps the companies with him, he's outside the reach of Linden Lab's mighty ban hammer. The second reason is that he allows himself to list firms from other worlds, perhaps the Entropia Universe or IMVU. If it works, it could be amazing.
However, also I've got to wonder about the profitability of HCL at this point. We know HCL has defaulted twice on its bonds, and has had no income for 50-some days and counting. HCL owns an island with low occupancy, but tier still comes due, as well as a hefy (and ad-free, I believe) web server. According to the HCL income statements, HCL had L$8.3 million in profit (neglecting the L$2.78 million they owe in bond interest currently*) ending January 1, which is about USD$31,300. I'm not saying they're going bankrupt right away, but between all the expenses (who pays for Connell's RL expenses, anyway?) I've got to wonder if this conversion to WICs isn't just all smoke and mirrors to mitigate some deposit liabilities.
With no one demanding Linden dollars, who is to say what's happening to those dollars? While there may be an initial "dump the WICs" session, I imagine the WIC will be fairly illiquid. Some hefty transaction fees could make sure people keep their "game tokens" as WICs and not as Lindens, allowing Connell free use of all the Lindens deposited into the WSE.
But enough of the theories, I have a more important question to the CEOs of the WSE: Which of you will stand by a twice-defaulted exchange moving away from your primary transaction currency? Which of you will remain next to the CEO who has played a major role in the collapse of not one, but two of Second Life's major banking institutions? And how will you justify it to your investors?
*If anyone can explain to me how you can manage to post an L$8.3 million profit and yet not have L$2.8 million to pay your bondholders with, I'd love to hear that reasoning. Please include the mathematics behind it.
Sunday, February 24, 2008
Lessons in FM: Part VII - Futures
In one of my previous posts, I mentioned something about the mathematics of futures contracts and asked if anyone would like for me to expound upon the reference I made, and my co-author Samantha Goldflake (as well as other readers) called me out on it, so here goes.
First, I'd like to introduce what a financial derivative is, and from that what a futures contract is and how to value it. A financial derivative has nothing to do with the slope of a tangent line, but rather is an asset which derives its value from some underlying asset. Examples of this include mutual funds, put and call options, interest rate swaps, and futures. These assets all have no value whatsoever on their own, but only derive their value from what some other asset is doing. Many of the stocks in SL are actually financial derivatives.
As a personal note, I love financial derivatives. Financial derivatives are power. I've been asked, and have provided, guides and advice as to how to implement financial derivatives in Second Life to various exchange bigwigs, but so far nothing has come above of it. If any of you are considering doing something with derivatives, please send me an IM - I'd love to be involved.
To me, the most viable financial derivative for Second Life would be a futures contract. A futures contract specifies that an investor will either buy or deliver a set amount of an underlying asset at a set price at a set time. There is no option as to whether or not this sale/purchase will take place - it is set by the contract.
A lot of the numbers you hear tossed about in First Life financial commodities are actually futures numbers. The price of oil, for example, is almost always quoted as a futures price. The same is true with gold, silver, and other precious metals.
So how could you use this in Second Life? Simple - futures on the LindeX. Set up a price and a date, and then you've got a futures contract with USD for L$. Measures would have to be taken to prevent simply bailing out on the contract, but having investors place and x% deposit for taking the contract would probably suffice, depending on what x is.
Regardless, we may wish to know how to price these funky things called futures. It's actually surprisingly simple, and most of the mathematics I've already covered in my first Lessons in FM: Part I - Present Value. Technically, futures contracts with strike prices (the price specified in the contract) equal to the expected cost have zero premium, although in real trading there is always some transaction cost to doing this.
I slipped in the word "expected" to the definition above for a reason. Suppose we're doing a futures contract on a five-year zero-coupon bond yielding 10% per year, costing 1000 now and with an expiration date of 6 months from now. If the strike price is 1000, that contract will actually trade at a premium because 6 months from now the bond is worth more than 1000. We would expect it to be worth
1000*(1.10)1/2 = 1048.81
So the contract actually has a value of 48.81. For the contract to have zero premium, it must have a strike at the expected price of 1048.81, and then it will have zero premium.
First, I'd like to introduce what a financial derivative is, and from that what a futures contract is and how to value it. A financial derivative has nothing to do with the slope of a tangent line, but rather is an asset which derives its value from some underlying asset. Examples of this include mutual funds, put and call options, interest rate swaps, and futures. These assets all have no value whatsoever on their own, but only derive their value from what some other asset is doing. Many of the stocks in SL are actually financial derivatives.
As a personal note, I love financial derivatives. Financial derivatives are power. I've been asked, and have provided, guides and advice as to how to implement financial derivatives in Second Life to various exchange bigwigs, but so far nothing has come above of it. If any of you are considering doing something with derivatives, please send me an IM - I'd love to be involved.
To me, the most viable financial derivative for Second Life would be a futures contract. A futures contract specifies that an investor will either buy or deliver a set amount of an underlying asset at a set price at a set time. There is no option as to whether or not this sale/purchase will take place - it is set by the contract.
A lot of the numbers you hear tossed about in First Life financial commodities are actually futures numbers. The price of oil, for example, is almost always quoted as a futures price. The same is true with gold, silver, and other precious metals.
So how could you use this in Second Life? Simple - futures on the LindeX. Set up a price and a date, and then you've got a futures contract with USD for L$. Measures would have to be taken to prevent simply bailing out on the contract, but having investors place and x% deposit for taking the contract would probably suffice, depending on what x is.
Regardless, we may wish to know how to price these funky things called futures. It's actually surprisingly simple, and most of the mathematics I've already covered in my first Lessons in FM: Part I - Present Value. Technically, futures contracts with strike prices (the price specified in the contract) equal to the expected cost have zero premium, although in real trading there is always some transaction cost to doing this.
I slipped in the word "expected" to the definition above for a reason. Suppose we're doing a futures contract on a five-year zero-coupon bond yielding 10% per year, costing 1000 now and with an expiration date of 6 months from now. If the strike price is 1000, that contract will actually trade at a premium because 6 months from now the bond is worth more than 1000. We would expect it to be worth
So the contract actually has a value of 48.81. For the contract to have zero premium, it must have a strike at the expected price of 1048.81, and then it will have zero premium.
To value these contracts then, you have to figure out your payoff and then discount it back to the present value. That's where my previous post comes into play - present value. The payoff on a forward contract is simply:
With the profit equal to
Therefore, to calculate the value for a futures contract expiring at time t, just calculate
Where i is the interest rate being used. i varies depending on what you're valuing. With bonds, it's the interest rate. With stocks, it tends to be the dividend yield. With currencies, it's the interest rate in the currency you're using. So, for my futures contract on the LindeX, we'd have to use the Second Life interest rate (or USD interest rate, if we were buying the Lindens) to discount to present value.
I hope this helps demonstrate what futures are and how they work. As I mentioned above, they're used quite frequently in real-life commodity trading, and almost every farmer in the United States is familiar with them. (They tend to sell futures contracts early in the season to ensure they sell their crop at harvest.) If you have any questions, by all means ask!
GM
Saturday, February 23, 2008
The Depreciation of Trust
The SLW conversion is complete, and traders on SL CapEx are now fully capable of withdrawing Lindens from the sales of their stocks. Yet, much work remains to be done.
On the public relations front, the most pressing issue I can see is newbies who somehow have gone blindly throughout life with no comprehension whatsoever of how a stock market functions. They stumble in, rant about where their money is gone, are pointed to a news posting, and then slowly realize the truth of the matter: Their portfolio is now worth 55% of what it was when they were a happy JTF Bank customer (current SLW price is 0.55-ish).
This problem is compounded by the fact that many of these customers don't speak English as a first language or maybe even at all. I do not fault these people for being confused, as it's a complex enough topic to handle for native speakers like myself. CapEx has made a good effort in reaching out to these people, and I hope CEOs are doing the same. Verballis may be able to help.
However, now it is time to look at another issue of the conversion: Trust. Trust is a funny thing to talk about in the financial, economic, or mathematical sense of the word. It certainly has value, but yet how to value it remains a near mystery. The branch of study known as Game Theory delves into this topic in great detail by applying certain "games" that try to quantify trust into a dollar value. If you ever hear of someone looking for volunteers for a Game Theory study, sign up - you will most likely walk out of the room with cash.
SLW presents another interesting way to try to quantify trust. Arbitrage Wise has promised to pay L$1.03 for each share of SLW at some future date. He has not released a date when this can be expected to occur, however. So, the question then becomes, how much is a promised L$1.03 from Wise worth? As mentioned above, it is currently worth L$0.55.
The far more interesting thing to me, however, is that this value is decreasing. After its initial volatility, SLW appears to have established a downward trend of about L$0.03 per day. (To be fair, one day it did rise L$0.03, but then fell L$0.06 the next.)
The market is giving Wise an idea of how much time it will be willing to wait for him to bring new funds into the market. For former depositors, these shares represent forward contracts of L$1.03 with an unspecified settlement date. I believe what is causing them to increase is a perceived increase in the risk premium or settlement date of SLW, or both. (Note: If anyone would like me to go through the mathematics of this, let me know and I'll work up another Lessons of FM for it. Don't be afraid to ask - it's just too much for this post.) At present, the market appears to be losing faith in Wise's promise at a rate of about 5% per day.
What can be done to avoid this? Well, this post on the CapEx forums caught my eye. While I don't agree with the abrupt manner the request is presented in, I do agree with the premise: it's time for a show of financial power and honestly from Wise. L$100,000 would go a long way towards buying some faith back in SLW, as would a metric posted somewhere showing how many shares have been repurchased to date. Even better is the fact that with renewed faith will come new buyers, pushing the price up and getting the most vocal and impatient of the depositors out the door, which giving the shares to more patient and positive investors.
I await a price spike.
On the public relations front, the most pressing issue I can see is newbies who somehow have gone blindly throughout life with no comprehension whatsoever of how a stock market functions. They stumble in, rant about where their money is gone, are pointed to a news posting, and then slowly realize the truth of the matter: Their portfolio is now worth 55% of what it was when they were a happy JTF Bank customer (current SLW price is 0.55-ish).
This problem is compounded by the fact that many of these customers don't speak English as a first language or maybe even at all. I do not fault these people for being confused, as it's a complex enough topic to handle for native speakers like myself. CapEx has made a good effort in reaching out to these people, and I hope CEOs are doing the same. Verballis may be able to help.
However, now it is time to look at another issue of the conversion: Trust. Trust is a funny thing to talk about in the financial, economic, or mathematical sense of the word. It certainly has value, but yet how to value it remains a near mystery. The branch of study known as Game Theory delves into this topic in great detail by applying certain "games" that try to quantify trust into a dollar value. If you ever hear of someone looking for volunteers for a Game Theory study, sign up - you will most likely walk out of the room with cash.
SLW presents another interesting way to try to quantify trust. Arbitrage Wise has promised to pay L$1.03 for each share of SLW at some future date. He has not released a date when this can be expected to occur, however. So, the question then becomes, how much is a promised L$1.03 from Wise worth? As mentioned above, it is currently worth L$0.55.
The far more interesting thing to me, however, is that this value is decreasing. After its initial volatility, SLW appears to have established a downward trend of about L$0.03 per day. (To be fair, one day it did rise L$0.03, but then fell L$0.06 the next.)
The market is giving Wise an idea of how much time it will be willing to wait for him to bring new funds into the market. For former depositors, these shares represent forward contracts of L$1.03 with an unspecified settlement date. I believe what is causing them to increase is a perceived increase in the risk premium or settlement date of SLW, or both. (Note: If anyone would like me to go through the mathematics of this, let me know and I'll work up another Lessons of FM for it. Don't be afraid to ask - it's just too much for this post.) At present, the market appears to be losing faith in Wise's promise at a rate of about 5% per day.
What can be done to avoid this? Well, this post on the CapEx forums caught my eye. While I don't agree with the abrupt manner the request is presented in, I do agree with the premise: it's time for a show of financial power and honestly from Wise. L$100,000 would go a long way towards buying some faith back in SLW, as would a metric posted somewhere showing how many shares have been repurchased to date. Even better is the fact that with renewed faith will come new buyers, pushing the price up and getting the most vocal and impatient of the depositors out the door, which giving the shares to more patient and positive investors.
I await a price spike.
Wednesday, February 20, 2008
SLW Follow-Up
Sometimes markets roar, and sometimes they whisper. Check out my price prediction of SLW below, and then go look at what it's trading at now. I love financial math.
Note: at the time of this writing, SLW has a bid of 0.60 and an ask of 0.64, and has been about that level for nearly 24 hours.
Note: at the time of this writing, SLW has a bid of 0.60 and an ask of 0.64, and has been about that level for nearly 24 hours.
Saturday, February 16, 2008
SLW Conversion Commentary
On Wednesday night I contacted Bogart Beck about raising the upper-level circuit breakers on CapEx in expectation of heavy trading the following day. I was right.
I'm not gloating too much - it doesn't take a great leap of logic to see that people are scared of SLW and will hold on to just about any other security in order to get rid of the possibility of having them. That's what's pushing CapEx prices up currently. Investors aren't trading Linden dollars anymore - they're trading SLW shares for other shares, and trying to get the best rate they can. Although JTF/CapEx has fixed a price target of L$1.03 for SLW, investors clearly aren't buying that.
I closely watch the SLR stock price, so I'm going to use it for an example. For the past few months, it's been creeping up from L$0.50 to L$0.75, and throughout January has held pretty steady around L$0.75. Today, however, it hit L$1.20. That's an increase of 60%! To me, that's not an increase in the value of SLR, but rather a decrease in the value of SLW. Since we know the share value of SLW is supposed to be L$1.03, we can solve to find out what these traders are valuing SLW at (maximum):
L$0.75 / x = L$1.20
x = L$0.625
These buyers are putting the SLW value at less than L$0.63 each. Looks like the market is expecting a panic...but we already knew that. You can't even read the CapEx forums now without some head-in-the-sand noob screaming "I WNAT MY MONEYS BACK!!! NOW!!!" I even heard a trader in CapEx today claiming that he was going to buy some BTR in hopes of selling it quickly at L$75.00 each. Market forces quickly brought the ask prices back in line, dashing the hopes of this trader, but it still served as an example to me of how confused these traders can get.
But let's stop keeping pace with the market at this point. Let's step up our pace and think one or two steps ahead of the general traders. We know the market is expecting a crash, and I've heard several big players say that they'll happily buy up cheap SLW shares from these fools. I may even throw in a few lowball bid offers in hopes of downward spikes. Those big players may keep SLW above the catastropic predictions and calculations the market is currently generating.
Also, everything I can see says that people are already ditching their SLW - they're just doing it by buying other stocks. That shrinks the supply of SLW shares available from the most active traders, which is another upward thrust for SLW prices. I still think it'll fall below L$1.00 in a heartbeat, but maybe it won't go so low as the calculation above suggests.
These traders and bank depositors want their cash. I suspect they'll take a hit to get to it. But they're not holding SLW shares anymore - they're holding some of their favorite company, or maybe every company. Therefore, I expect the drop in prices to be more severe among other CapEx companies than SLW, at least after the major spikes stabilize. How severe? I'm not sure, but bargain investors will find a huge sale going on at the CapEx next week.
So how do you make money in this market? I've been placing high sell orders on all my stocks and I'm preparing to hold SLW shares until prices stabilize. All orders should be canceled at the conversion, so there is no harm in placing them. Once SLW prices are steady, it should just be a matter of cashing out.
Unless, of course, something unexpected happens.
Saturday, February 9, 2008
Hope Capital Credit Rating
According to the prospectus of Hope Capital Bonds (HCB), they were supposed to issue a coupon payment in the form of a dividend on 2/2/2008. For the second time in a row (as well as the only times) HCB has defaulted to its investors.
It seems only fitting then that a credit rating of D be assigned to Hope Capital Ltd, for failing to pay interest to creditors.
It seems only fitting then that a credit rating of D be assigned to Hope Capital Ltd, for failing to pay interest to creditors.
Thursday, February 7, 2008
Musings
I've been studying more for my next RL actuarial exam, Modeling Financial Economics, and it always makes me think about the depth of subtleties of markets. The lesson on equivalent, or replicating, portfolios that I gave in a Lessons in FM has so much power to it, but is something that is also so hidden very few can see it. Did you know, for example, that you can replicate a call option by simply buying and selling stocks and low-risk bonds? (Specifically, for call options, you borrow some money, aka sell a bond, to buy the stock, and then they become equivalent. Of course, you have to get the proportions right, and that's not exactly easy to do...)
Yet, despite the depth and breadth of these studies, which I just get exposed to the tip of the iceberg on, it saddens me that so few are in on these great secrets. I doubt less than 1% of the avatars involved in the SL finances could tell me what an option delta is. If we make it only CEOs, maybe we can move that up to 20%. Can any fund managers in SL tell me what the volatility of their portfolio is? How is it correlated to the market (aka its beta)? Where is the greatest risk exposure? I laugh (usually aloud) at any prospectus which simply lists SL closing down or the devaluation of the Linden Dollar as the lone risk factors to their business.
Please note, I'm not trying to criticize anyone here. The subjects I'm talking about are definitely high-end mathematics, and would require some study which is not required of CEOs in SL. I'm only sad that although the SL capital markets have come so far in the past year, they still have so very far to go.
Tuesday, February 5, 2008
Surprise!
Unless the WSE goes and opens in the next five hours (while I'm asleep), then they will be late on their promise to open within 30 days.
Who's surprised? Not I.
Who's surprised? Not I.
Sunday, February 3, 2008
Watching
This week should be an interesting week in SL finances. We've got a couple of big events which I expect to break, and there will of course be the others that we never see coming.
First up, I'm curious to see how the Metaverse Investment Fund does on its second week in the market. I wrote an (objective) article about the MIF on SL Reports, but this is my space to post so I don't have to be objective here - just respectful - something a few of the commentators on that story seem to be having trouble understanding.
Anyway, I've known Shaun since my early days in SL, and he's a good fox and has done very well investing. That being said, I don't think this market merits any new investments whatsoever, and I'm still not convinced about the 3.5% commissions on both sides of the transaction. That means you've got to earn about 6.9% just to break even! That's too steep for my value investment mindset.
Next, this week should see the re-opening of the World Stock Exchange. As was posted on January 6, 2008,
First up, I'm curious to see how the Metaverse Investment Fund does on its second week in the market. I wrote an (objective) article about the MIF on SL Reports, but this is my space to post so I don't have to be objective here - just respectful - something a few of the commentators on that story seem to be having trouble understanding.
Anyway, I've known Shaun since my early days in SL, and he's a good fox and has done very well investing. That being said, I don't think this market merits any new investments whatsoever, and I'm still not convinced about the 3.5% commissions on both sides of the transaction. That means you've got to earn about 6.9% just to break even! That's too steep for my value investment mindset.
Next, this week should see the re-opening of the World Stock Exchange. As was posted on January 6, 2008,
We are upgrading many areas of our services and the website as part of our launch for the WSE 4.0 platform. This is a huge undertaking and we have now entered a phase of development that requires the WSE to close all trading and transactions for "up to" 30 days.
I still haven't figured out why "up to" deserves quotes, but I do know how to count, and February 5th is 30 days from January 6th. Day traders get ready - I expect some serious volatility, mostly in the downward direction, when WSE goes live again. There will be lots of investors just wanting to get their cash out, and they've been cooped up for a whole month to get nervous about it. Extremely brave souls can find a good buyers market here. I'm just hoping we lose that audio announcement on the front page.
Finally, during this week we'll get a peek inside the financials of companies required to do monthly reporting. It'll be our first glance at how badly the banking ban hit the Second Life economy, and the Lindens should be releasing economic statistics sometime in the near future as well.
This past week, I posted my first set of financials for SL Reports...and only one person ventured a question. I'm hoping this is because my statements and commentary were sufficient, but honestly I was expecting an onslaught of inquiries, both on forums and in-world. Oh well - no news is good news...unless you need web traffic.
GM
Tuesday, January 29, 2008
Currency Trading
So I've begun my first foray into trading on the LindeX for profit, as opposed to simple conversion. It seems to be going well so far - the worst case scenario is that I could get stuck with surplus US Dollars that I couldn't get rid of. Oh darn.
It seems to me that the profitability at the current best rates (Sell = L$265/USD, Buy = L$276/USD) approaches 0.005 or so as the amount of Lindens trades increases to infinity. This takes into account the 3.5% transaction fee on the sell side, but disregards the $0.30USD fee on the buy side (argument: as the amount of money trades increase, the 30 cent fee becomes insignificant on the total rate of return). Here's the equation, for those interested:
(1 - .035) * 276 / 265 = 1.00506604...
I've also noticed that those selling Linden Dollars appear to be smarter than those buying them. The reason is because I sold my Lindens pretty quickly, meaning there were lots of market buys (people trading USD at whatever rate for L$). However, my USD have been sitting tight for over 24 hours now, despite the quantity offered at 276 being much lower than that offered at 265. That means that not as many SL'ers are pushing the "sell at market" button when they go to sell their Lindens. Interesting, and slightly reminiscent of P.T. Barnum.
Any hints for me from those of you out there who have more experience than I do in this realm?
GM
P.S. I have a cute Excel workbook for my trades, if anyone's interested. Appears to be accurate within 0.01USD, although your results may vary.
It seems to me that the profitability at the current best rates (Sell = L$265/USD, Buy = L$276/USD) approaches 0.005 or so as the amount of Lindens trades increases to infinity. This takes into account the 3.5% transaction fee on the sell side, but disregards the $0.30USD fee on the buy side (argument: as the amount of money trades increase, the 30 cent fee becomes insignificant on the total rate of return). Here's the equation, for those interested:
(1 - .035) * 276 / 265 = 1.00506604...
I've also noticed that those selling Linden Dollars appear to be smarter than those buying them. The reason is because I sold my Lindens pretty quickly, meaning there were lots of market buys (people trading USD at whatever rate for L$). However, my USD have been sitting tight for over 24 hours now, despite the quantity offered at 276 being much lower than that offered at 265. That means that not as many SL'ers are pushing the "sell at market" button when they go to sell their Lindens. Interesting, and slightly reminiscent of P.T. Barnum.
Any hints for me from those of you out there who have more experience than I do in this realm?
GM
P.S. I have a cute Excel workbook for my trades, if anyone's interested. Appears to be accurate within 0.01USD, although your results may vary.
Saturday, January 26, 2008
Irony
From an announcement on the Ancapistan Capital Exchange (ACE):
FWD IPO Reversed
Due to drastically insufficent investment, this IPO, launched December 5th, 2007 does not appear likely to complete. For this reason we are reversing this IPO and returning funds to investors to reinvest elsewhere. We will keep you apprised of the CEO's future plans should they arise.
Interesting.
I didn't have a chance to see how FWD's IPO was going, but the ACE IPO, running concurrently on the same exchange, is 10.8% subscribed and has been listed since the start of the exchange. I would say it is suffering from "drastically insufficent investment" as well, but it stays on.
I leave my readers to draw conclusions as they like.
FWD IPO Reversed
Due to drastically insufficent investment, this IPO, launched December 5th, 2007 does not appear likely to complete. For this reason we are reversing this IPO and returning funds to investors to reinvest elsewhere. We will keep you apprised of the CEO's future plans should they arise.
Interesting.
I didn't have a chance to see how FWD's IPO was going, but the ACE IPO, running concurrently on the same exchange, is 10.8% subscribed and has been listed since the start of the exchange. I would say it is suffering from "drastically insufficent investment" as well, but it stays on.
I leave my readers to draw conclusions as they like.
Monday, January 21, 2008
Par Value
I'd like to take you all into a land that is not my expertise, but is so overly used and abused in the SL Capital Markets that it is necessary to visit once in awhile. That land is accounting, and we'll be travelling to the isle of stockholder's equity in this article, for a topic on the idea of par value of shares.
First, however, it is absolutely vital that everyone who travels to the land of accounting learn the balance equation. This equation is tattooed on the skull of every accountant and accounting major, and they have it in their minds at all times. This ancient secret of bookkeeping reads:
This is how I found an error in the SLR balance sheet, and posted about it here.
The assets and liabilities section are fairly straightforward. It seems to be that equity section that trips people up. For that section, I'm going to highlight how to figure the values placed in the "Common Stock" and "Paid-In Capital" lines, because I think it's a topic that is not emphasized enough.
Contrary to about every balance sheet I've looked at in SL, "Common Stock" does not refer to the market capitalization (shares * price) of a company. Instead, when a company sells stock, they should also set a par value for the stock, which is a fictional, very low (L$0.01 is what I've been recommending to those that ask) value to place on the shares. The remainder of the cash you receive is then added to that "Paid-In Capital" line, whose full name is actually "Paid-in capital in excess of par value." When you see the full name, it makes more sense.
Why bother correcting these? Well, if you treat your market capitalization as your equity section, then the accounting equation has to have correspondingly large assets or liabilities to keep in check. This is especially true if you kept a lot of shares back from public holdings. An example would help show this:
Suppose XYZ creates 10,000,000 shares, and sells them for L$1 each. Let's suppose the day afterwards, XYZ stock hits L$3.00 per share. If we use market value on the balance sheet, the company has spontaneously gotten L$20,000,000 richer! But in reality, nothing changed, so this is not an accurate picture.
Instead, the company should record (in my opinion) L$100,000 as common stock, L$9,900,000 as paid-in capital, and $10,000,000 as cash. Then, in subsequent balance sheets, leave the L$100,000 alone, and adjust other lines around it. This will be a better representation of XYZ's true value.
Disclaimer: I'm not an accountant. I'm an actuary. Real accountants, feel free to critique this as needed.
Source: This page of AccountingCoach.com
First, however, it is absolutely vital that everyone who travels to the land of accounting learn the balance equation. This equation is tattooed on the skull of every accountant and accounting major, and they have it in their minds at all times. This ancient secret of bookkeeping reads:
ASSETS = LIABILITIES + EQUITY
This is how I found an error in the SLR balance sheet, and posted about it here.
The assets and liabilities section are fairly straightforward. It seems to be that equity section that trips people up. For that section, I'm going to highlight how to figure the values placed in the "Common Stock" and "Paid-In Capital" lines, because I think it's a topic that is not emphasized enough.
Contrary to about every balance sheet I've looked at in SL, "Common Stock" does not refer to the market capitalization (shares * price) of a company. Instead, when a company sells stock, they should also set a par value for the stock, which is a fictional, very low (L$0.01 is what I've been recommending to those that ask) value to place on the shares. The remainder of the cash you receive is then added to that "Paid-In Capital" line, whose full name is actually "Paid-in capital in excess of par value." When you see the full name, it makes more sense.
Why bother correcting these? Well, if you treat your market capitalization as your equity section, then the accounting equation has to have correspondingly large assets or liabilities to keep in check. This is especially true if you kept a lot of shares back from public holdings. An example would help show this:
Suppose XYZ creates 10,000,000 shares, and sells them for L$1 each. Let's suppose the day afterwards, XYZ stock hits L$3.00 per share. If we use market value on the balance sheet, the company has spontaneously gotten L$20,000,000 richer! But in reality, nothing changed, so this is not an accurate picture.
Instead, the company should record (in my opinion) L$100,000 as common stock, L$9,900,000 as paid-in capital, and $10,000,000 as cash. Then, in subsequent balance sheets, leave the L$100,000 alone, and adjust other lines around it. This will be a better representation of XYZ's true value.
Disclaimer: I'm not an accountant. I'm an actuary. Real accountants, feel free to critique this as needed.
Source: This page of AccountingCoach.com
Sunday, January 20, 2008
Tic Tac (Toe)
If you're wondering about this blog post title, it's meant to represent both the clock accompanying us to January 22, when the new LL policy on inworld gambling will have effect and the tic-tac-toe game that apparently SL financial institutions have been playing with our beloved San Francisco company, in an attempt to get those 3 Xs on a straight row.
We've seen a lot of drama, the run on banks, all kinds of creative minds coming up with more or less viable ideas. One of the best I've seen around is the application inworld of the contractum trinius (which is not really a new idea, but proves that some issues can bite at us over the centuries). So far so good, but I've seen people cheering because the new policy was bypassed this way.
That's not right, for a simple reason. The company controlling the Second Life Grid could ban red hats and whatever, and for every workaround new policies can come up and they can be expanded, in a almost endless armfight.
Let's get back to the contractum trinius. At that time the Catholic Church prohibited usury and that's why our creative ancestors came up with a solution. Now, Linden Lab started from a completely different premise. Some think that they wanted to ease the work for RL banks and their future appearance in full force in our metaverse. Personally, I don't think this is true.
I'll make a long story short: too many frauds related to inworld banking. No need to provide links here, most likely you know of at least one. Those scandals got Linden Lab too much unwanted attention and bad press.
It's about time for the SL financial institutions still operating to do something in order to make things so Linden Lab won't have again to take a stance like the recent one. Over the last days almost everyone has been "flying solo" and with the only intent to keep operating past January 22. Period. At least that's what I gathered from the web. If I have missed something, my apologies. It's not been easy to surf through all the posts, blogs, websites and comments.
This may be the right time for the SLEC (Second Life Exchange Commission) to get its acts together and do something meaningful. This may be the right time for the Second Life Exchanges (as you may know I am the Communication and Public Relations Director for the VSTEX, virtual stock exchange in Second Life) to enforce their rules (which sometimes are unattended by the listed companies, with no consequences) and maybe expand them, so that listed companies are required to meet higher requirements and standards. Here I'm not talking about going "full GAAP", but looking at the companies on the VSTEX exchange, the situation can be disheartening.
Recently I started a simple audit of our companies. The first I started with failed to update the company prospectus for the last month cycle and most important they were reporting substantial profits that had not been distributed as per their dividends policy. Do I think that they did not distribute dividends as promised? No, I think that the numbers on their company prospectus were made up to make the company look good. Maybe those numbers were "hopes about profits", that they just forgot in the company prospectus. Whatever the reason, this is no good.
I can see why the exchanges can be "soft" when enforcing their rules, or why they requirements are pretty loose. They fear to lose ground to their competitors, to lose companies to other exchanges. This tactic is not gonna pay in the long run, 'cause it's just screaming "Linden Lab, do something about me".
We've seen a lot of drama, the run on banks, all kinds of creative minds coming up with more or less viable ideas. One of the best I've seen around is the application inworld of the contractum trinius (which is not really a new idea, but proves that some issues can bite at us over the centuries). So far so good, but I've seen people cheering because the new policy was bypassed this way.
That's not right, for a simple reason. The company controlling the Second Life Grid could ban red hats and whatever, and for every workaround new policies can come up and they can be expanded, in a almost endless armfight.
Let's get back to the contractum trinius. At that time the Catholic Church prohibited usury and that's why our creative ancestors came up with a solution. Now, Linden Lab started from a completely different premise. Some think that they wanted to ease the work for RL banks and their future appearance in full force in our metaverse. Personally, I don't think this is true.
I'll make a long story short: too many frauds related to inworld banking. No need to provide links here, most likely you know of at least one. Those scandals got Linden Lab too much unwanted attention and bad press.
It's about time for the SL financial institutions still operating to do something in order to make things so Linden Lab won't have again to take a stance like the recent one. Over the last days almost everyone has been "flying solo" and with the only intent to keep operating past January 22. Period. At least that's what I gathered from the web. If I have missed something, my apologies. It's not been easy to surf through all the posts, blogs, websites and comments.
This may be the right time for the SLEC (Second Life Exchange Commission) to get its acts together and do something meaningful. This may be the right time for the Second Life Exchanges (as you may know I am the Communication and Public Relations Director for the VSTEX, virtual stock exchange in Second Life) to enforce their rules (which sometimes are unattended by the listed companies, with no consequences) and maybe expand them, so that listed companies are required to meet higher requirements and standards. Here I'm not talking about going "full GAAP", but looking at the companies on the VSTEX exchange, the situation can be disheartening.
Recently I started a simple audit of our companies. The first I started with failed to update the company prospectus for the last month cycle and most important they were reporting substantial profits that had not been distributed as per their dividends policy. Do I think that they did not distribute dividends as promised? No, I think that the numbers on their company prospectus were made up to make the company look good. Maybe those numbers were "hopes about profits", that they just forgot in the company prospectus. Whatever the reason, this is no good.
I can see why the exchanges can be "soft" when enforcing their rules, or why they requirements are pretty loose. They fear to lose ground to their competitors, to lose companies to other exchanges. This tactic is not gonna pay in the long run, 'cause it's just screaming "Linden Lab, do something about me".
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Thursday, January 17, 2008
Is Interest the Devil?
First, go take a look over the 1/15/2008 post in this thread.
Now, several times in that post, Linden Labs appears to take a very anti-interest stance. This is quite curious to me. Interest is usually something considered fairly tame. Precise, but tame.
I happen to be an interest ninja. Not a ninja master, perhaps, but I've done some pretty hard material dealing with interest. I can confirm for you all, after nearly wearing out the decimal point button on my calculator, that interest is not evil.
I think Linden Labs is banking on the idea that the market will not exist if it doesn't have a way to pay itself. That's the only idea I can come up with for a reason to specifically target interest. The line of reasoning must be that if you take away the payout, the money inflow will shrivel up as well.
The question on many people's minds, including my friend Maelstrom, is how much money inflow is leaving SL now. The financial markets brought a lot of cash flow to Second Life, but quantifying that will not be easy. These graphs don't look pretty, though - especially the one about USD spent in Second Life. It's a pretty sharp decline after the gambling ban, and I doubt the banking ban will make things look any prettier when the newest statistics come out.
I don't think Linden Labs will let Second Life die so easily, however. Should incentives be necessary, however, I'll bet LL has a few tricks to play. What I'm wondering is if one of those tricks will be to loosen the Linden Dollar against the USD, and therefore if now would be an opportune time to cash out whatever Lindens can be spared. Thoughts?
Whatever the case, Linden Labs needs to learn a lesson that economists learned centuries ago: markets will not be thwarted. If someone wants to have interest on a loan, they'll have interest on a loan. They might call it something different, or set it up to be sneaky, but it'll happen. Heck, I still get invites to poker tables (I always turn them down, of course). If there are willing buyers (borrowers) and sellers (lenders), the market will find a way to carry on business as it sees fit, no matter how much wrangling it has to do to get there.
Now, several times in that post, Linden Labs appears to take a very anti-interest stance. This is quite curious to me. Interest is usually something considered fairly tame. Precise, but tame.
I happen to be an interest ninja. Not a ninja master, perhaps, but I've done some pretty hard material dealing with interest. I can confirm for you all, after nearly wearing out the decimal point button on my calculator, that interest is not evil.
I think Linden Labs is banking on the idea that the market will not exist if it doesn't have a way to pay itself. That's the only idea I can come up with for a reason to specifically target interest. The line of reasoning must be that if you take away the payout, the money inflow will shrivel up as well.
The question on many people's minds, including my friend Maelstrom, is how much money inflow is leaving SL now. The financial markets brought a lot of cash flow to Second Life, but quantifying that will not be easy. These graphs don't look pretty, though - especially the one about USD spent in Second Life. It's a pretty sharp decline after the gambling ban, and I doubt the banking ban will make things look any prettier when the newest statistics come out.
I don't think Linden Labs will let Second Life die so easily, however. Should incentives be necessary, however, I'll bet LL has a few tricks to play. What I'm wondering is if one of those tricks will be to loosen the Linden Dollar against the USD, and therefore if now would be an opportune time to cash out whatever Lindens can be spared. Thoughts?
Whatever the case, Linden Labs needs to learn a lesson that economists learned centuries ago: markets will not be thwarted. If someone wants to have interest on a loan, they'll have interest on a loan. They might call it something different, or set it up to be sneaky, but it'll happen. Heck, I still get invites to poker tables (I always turn them down, of course). If there are willing buyers (borrowers) and sellers (lenders), the market will find a way to carry on business as it sees fit, no matter how much wrangling it has to do to get there.
Saturday, January 12, 2008
And, He's Back
First, let me apologize to Guardian, the other bloggers, and the readers for not having posted lately. Quite honestly, I have no excuse except neglect due to other priorities.
Life has been a little hectic lately. After a couple months of retreat, I have decided to go back to work full-time. Job-hunting is the one thing I truly hate doing.
I always feel like I am being extremely "fake" in the letters of interest I send to potential employers. I always get so sick to my stomach writing my resumé, as I am forced to write flowery descriptions of past jobs that in all honesty I have truly hated.
Then... scheduling interviews. I actually do not drive anymore (long crappy story), so I rely on either public transportation (which is really BAD where I live) or friends/family to get me from Point A to Point B.
I've been dealing with all of it, though... quite nicely. I am almost 100% certain I will be back to the grind stone by the first of February.
Not sure why I went into all of that, LOL, but it somehow ended up here and frankly I am too tired at this point to edit it.
Perhaps, though, because of my hatred for job hunting... when I found out about the Linden Lab banking ban, I glued myself to the computer screen once again... to help out, to write, to just generally "observe" as this latest and greatest financial drama unfolded.
The day after the announcement, I logged in to see what I could do, and ended up helping at JT Financial. While we had a few angry customers, all in all everyone was very supportive, primarily upset at Linden Lab....... but mostly frustrated with the situation.
As I have read the policy, it would appear that banking as we know it is dead. With the cessation of interest payments, there will be virtually no reason to set up or continue shop with any form of banking script as we know it today.
Now, that being said... the existing banks out there have an opportunity. If they truly have the liquidity that most of them claim, they will be able to make investments into retooling their businesses. Shopping portals, financial service providers, payment services... all are fantastic possibilities with the right marketing and the right transitions. Customers may still be unable to access all of their funds in the short term, but at least the bank owner would be making a clear effort for the continuation of business.
I don't understand how some people, including me in the past couple days, have blown things so out of proportion through over-analysis and just "freaking out" in general.
I can only say that some of banks' (and customers') actions in the midst of this crisis are confusing. Some are totally ignoring it, some are overreacting to it, and some are clearly overthinking their forward path. A few of the ideas I have heard passed around about how to continue operations are incredibly ridiculous, unrealistic, or unworkable.
I truly applaud people who are trying their hardest and "thinking big" but sometimes it just helps to take a day off, watch television, or go swimming... to get a grip on reality and take control of your thoughts.
There are other banks that I have seen who are truly responding to the matter calmly, to the best of their ability. They're telling the truth to their customers and doing what they can to take care of a bad situation.
The one thing I love about almost every single bank in SL is this... every week for the past six months AT LEAST, it seemed like a different bank owner was name-dropping the Lindens in some form or another. By their own accounts, every single bank owner in SL was a friend of Linden Lab. "Bob Linden told us we could do this" or "We've been working with our contact at Linden Lab."
I find it curious that all of the second-cousin and blood-brother Lindens just kicked the floor out from underneath the people that they seemed to talk to the most... virtual bankers.
In any event, I think that Second Life will survive this latest blow. I think we'll see the successful bankers go on to become successful in other areas of business, and I think in the end everyone will agree that in-world banking has significantly contributed to the history of our virtual world.
For now, like you, I sit back and wait... ;)
In any event, that was my quick update for now... quite broad and dull, but the only thing I could possibly come up with after writing so much at SL Reports the past couple days.
On that note, as well... I should mention that I am uncertain how much I will be around the next couple days. I will try, at minimum, to keep track of the latest SL News to stay up to speed with things... but will probably be somewhat silent barring the appearance of something else interesting at the official Second Life blog.
Xavier Mohr
Life has been a little hectic lately. After a couple months of retreat, I have decided to go back to work full-time. Job-hunting is the one thing I truly hate doing.
I always feel like I am being extremely "fake" in the letters of interest I send to potential employers. I always get so sick to my stomach writing my resumé, as I am forced to write flowery descriptions of past jobs that in all honesty I have truly hated.
Then... scheduling interviews. I actually do not drive anymore (long crappy story), so I rely on either public transportation (which is really BAD where I live) or friends/family to get me from Point A to Point B.
I've been dealing with all of it, though... quite nicely. I am almost 100% certain I will be back to the grind stone by the first of February.
Not sure why I went into all of that, LOL, but it somehow ended up here and frankly I am too tired at this point to edit it.
Perhaps, though, because of my hatred for job hunting... when I found out about the Linden Lab banking ban, I glued myself to the computer screen once again... to help out, to write, to just generally "observe" as this latest and greatest financial drama unfolded.
The day after the announcement, I logged in to see what I could do, and ended up helping at JT Financial. While we had a few angry customers, all in all everyone was very supportive, primarily upset at Linden Lab....... but mostly frustrated with the situation.
As I have read the policy, it would appear that banking as we know it is dead. With the cessation of interest payments, there will be virtually no reason to set up or continue shop with any form of banking script as we know it today.
Now, that being said... the existing banks out there have an opportunity. If they truly have the liquidity that most of them claim, they will be able to make investments into retooling their businesses. Shopping portals, financial service providers, payment services... all are fantastic possibilities with the right marketing and the right transitions. Customers may still be unable to access all of their funds in the short term, but at least the bank owner would be making a clear effort for the continuation of business.
I don't understand how some people, including me in the past couple days, have blown things so out of proportion through over-analysis and just "freaking out" in general.
I can only say that some of banks' (and customers') actions in the midst of this crisis are confusing. Some are totally ignoring it, some are overreacting to it, and some are clearly overthinking their forward path. A few of the ideas I have heard passed around about how to continue operations are incredibly ridiculous, unrealistic, or unworkable.
I truly applaud people who are trying their hardest and "thinking big" but sometimes it just helps to take a day off, watch television, or go swimming... to get a grip on reality and take control of your thoughts.
There are other banks that I have seen who are truly responding to the matter calmly, to the best of their ability. They're telling the truth to their customers and doing what they can to take care of a bad situation.
The one thing I love about almost every single bank in SL is this... every week for the past six months AT LEAST, it seemed like a different bank owner was name-dropping the Lindens in some form or another. By their own accounts, every single bank owner in SL was a friend of Linden Lab. "Bob Linden told us we could do this" or "We've been working with our contact at Linden Lab."
I find it curious that all of the second-cousin and blood-brother Lindens just kicked the floor out from underneath the people that they seemed to talk to the most... virtual bankers.
In any event, I think that Second Life will survive this latest blow. I think we'll see the successful bankers go on to become successful in other areas of business, and I think in the end everyone will agree that in-world banking has significantly contributed to the history of our virtual world.
For now, like you, I sit back and wait... ;)
In any event, that was my quick update for now... quite broad and dull, but the only thing I could possibly come up with after writing so much at SL Reports the past couple days.
On that note, as well... I should mention that I am uncertain how much I will be around the next couple days. I will try, at minimum, to keep track of the latest SL News to stay up to speed with things... but will probably be somewhat silent barring the appearance of something else interesting at the official Second Life blog.
Xavier Mohr
Banter on the Banking Ban
It's been a rough few days for the Second Life financial markets. Linden Labs announced that banking, at least in the guaranteed interest form, is illegal in Second Life. The resounding response from my SL circle of contacts has been "What about stock markets?" to which no answer has been readily given. The supposition is that the stock markets will be kosher with Linden Labs, but this has yet to be confirmed through official, exact, announcement.
There have been many comments trying to reassure investors to not panic, but I can't really blame them for panicking. If the FDIC suddenly said my bank was no longer legal, I think I'd go drive up to the local branch and withdraw some money. I use the FDIC as an example because Linden Labs is the closest thing to a true insurance corporation (apologies to The Rock) that your Joe Average Investor has in Second Life. Take that last safety net away (not that there was much of one to begin with, but they did help out LLBT), and you have nothing. Panic is a natural reaction.
The expected outcomes came quickly: stock price crashes, insolvency of banks, outrage, denial, etc. However, now we must look ahead. Owners must reassure their investors or liquidate and distribute final payments. Exchanges must find some way to remain compliant, although I feel this action by Linden Labs was a warning shot for the stock exchanges. Cry foul all you want, I think the day is coming where stock exchanges will be no more for one reason or another. I just don't know when that day is.
So what is a financier to do now? I see a few options:
Until next time,
GM
There have been many comments trying to reassure investors to not panic, but I can't really blame them for panicking. If the FDIC suddenly said my bank was no longer legal, I think I'd go drive up to the local branch and withdraw some money. I use the FDIC as an example because Linden Labs is the closest thing to a true insurance corporation (apologies to The Rock) that your Joe Average Investor has in Second Life. Take that last safety net away (not that there was much of one to begin with, but they did help out LLBT), and you have nothing. Panic is a natural reaction.
The expected outcomes came quickly: stock price crashes, insolvency of banks, outrage, denial, etc. However, now we must look ahead. Owners must reassure their investors or liquidate and distribute final payments. Exchanges must find some way to remain compliant, although I feel this action by Linden Labs was a warning shot for the stock exchanges. Cry foul all you want, I think the day is coming where stock exchanges will be no more for one reason or another. I just don't know when that day is.
So what is a financier to do now? I see a few options:
- Go private: Instead of being able to invest through an ATM, all transactions would need to take place avatar-to-avatar. This would also allow for some extra legal scrutiny, like First Life promissory notes by peer-to-peer lending sites.
- Eliminate the Lindens: Keep things exactly as they are, but run them in First Life currencies through PayPal. I personally don't like this idea because it screams "regulate me!"
- Survival of the Fittest: Try to satisfy the Lindens, law enforcement, stockholders, and make a profit good enough to justify the massive amount of time put in to do it. Good luck.
- Group Mechanics: Could a public corporation in Second Life be run through the mechanics of a Second Life group? I think that would have an easier time being approved than an ATM-based exchange.
- A New Model: You fill in the blank here. The next generation of Second Life money attractors. First it was gambling, now it is stock markets. What's next? I think there may be some room in skill-based player games, for example.
Until next time,
GM
Thursday, January 10, 2008
Apologies
My apologies for not posting a prompter article about the banking ban here. I have a good friend who was taken to the hospital recently, and so that has taken up most of my writing time. Please keep her in your thoughts/prayers.
Hopefully I can get some analysis out this weekend.
Remember, RL > SL.
GM
Hopefully I can get some analysis out this weekend.
Remember, RL > SL.
GM
Tuesday, January 8, 2008
The Fall of Banks in Second Life
If you haven't read it yet - go read this post from the LL official blog.
Initial reactions, to be updated later:
Update: Reports are coming in of the Linden dollar falling in price. Can't confirm it right now.
Update: Lots of people at JTF complaining. Please don't panic, everyone...unless you don't trust your CEOs
Arbitrage Wise Reaction: LINK
WSE Reaction: LINK
ISE Reaction: LINK
VSTEX Reaction: LINK
Virtually Blind Reaction: LINK
Robert Bloomfield Reaction: LINK
Questions still to be answered:
Initial reactions, to be updated later:
- Expect a market panic and a drop in security prices across the board, whether or not the exchange qualifies as a bank or not.
- Bank panics will abound. Smart banks will take their ATMs offline before they run out of deposits. Dumb ones will not, and will run out of cash as investors panic and withdraw.
- This is the time to see if CEOs are honorable or crooks. Don't expect to get all your money back, but expect to get some - and most of the cash portion.
Update: Reports are coming in of the Linden dollar falling in price. Can't confirm it right now.
Update: Lots of people at JTF complaining. Please don't panic, everyone...unless you don't trust your CEOs
Arbitrage Wise Reaction: LINK
WSE Reaction: LINK
ISE Reaction: LINK
VSTEX Reaction: LINK
Virtually Blind Reaction: LINK
Robert Bloomfield Reaction: LINK
Questions still to be answered:
- Are exchanges paying no interest exempted from this ban?
- If exchanges are permitted, are "bonds" now banned, or are they also treated as equity?
- Which companies will honor (as best they are able) their depositors and/or shareholders?
Monday, January 7, 2008
BNT: An Example in Expectations
Over on AnCapEx, Brautigan & Tuck holdings has published their quarterly (ok, four-month) financial statements. To quote the announcement,
In my economics classes, we learned about some of the common market forces which affect demand curves, such as income, tastes and preferences, price of compliments/substitutes, and (most mysteriously to me) expectations.
In my finance classes, we learned about why investors choose to invest in a given security or project. We learned that investors prefer more money to less money, money sooner to money later, and less risk to more risk. The interplay of these preferences creates the wonderful stock charts we all know and love from First Life and Second Life.
I think that within these simple concepts lies the heart of the situation above. Despite having assets at three times the share price, investors simply don't expect to get anything from them. To be honest, BNT hasn't given them much to hope for: to my recollection, there has only been one dividend and no buybacks (although Intlibber did eliminate a large swath of his own holdings, this had little effect on the market price since it didn't affect the floating shares) to speak of. The most faithful shareholders of BNT, those that purchased the stock at its IPO on the World Stock Exchange, have lost 76% on their L$1.00 per share investment.
So is it any wonder that the price flutters with the whims of the day traders instead of reaching its NAV? With no history of dividends, buybacks, and little hope of actually getting L$0.72 per share for your BNT, the market seems perfectly justified (to me) in withholding its Lindens from purchasing anything but a token amount of BNT, and so it seems to have progressed.
There has been some comparison of BNT to Microsoft (NYSE:MSFT) in the past. I can't link to it because I don't think it has been explicitly written down before, but trust me on this one. However, the differences are beginning to show between the technological juggernaut and BNT holdings:
...while our profits are nothing to boast about, we were able to post nearly 27% growth in NAV despite a downturn in real estate asset values. NAV is now L$ 0.76, above the L$ 0.60 value BNT was at after we restructured our shares and eliminated 67 million of the CEOs personal shares in the largest voluntary elimination of personal wealth in SL history.Well, this is an interesting situation. As of this writing, the price of a share of BNT stock is L$0.24, and it has been around that level for some time. If the NAV of this stock is L$0.72 as claimed, why aren't market forces pushing it up to that level?
The growth in our NAV is confirmation that BNT's long term strategy of no dividends, focusing on growth, has been the right one. Despite an in-world depression, banking crash, and downturn in the capital markets as well as real estate markets, BNT continues to grow, and by growing is returning value to the shareholder the old fashioned way. This share value is not short term gimmickry like those CEOs who fake up big dividends that mostly winds up in their own pockets. This is real value in a real company.
In my economics classes, we learned about some of the common market forces which affect demand curves, such as income, tastes and preferences, price of compliments/substitutes, and (most mysteriously to me) expectations.
In my finance classes, we learned about why investors choose to invest in a given security or project. We learned that investors prefer more money to less money, money sooner to money later, and less risk to more risk. The interplay of these preferences creates the wonderful stock charts we all know and love from First Life and Second Life.
I think that within these simple concepts lies the heart of the situation above. Despite having assets at three times the share price, investors simply don't expect to get anything from them. To be honest, BNT hasn't given them much to hope for: to my recollection, there has only been one dividend and no buybacks (although Intlibber did eliminate a large swath of his own holdings, this had little effect on the market price since it didn't affect the floating shares) to speak of. The most faithful shareholders of BNT, those that purchased the stock at its IPO on the World Stock Exchange, have lost 76% on their L$1.00 per share investment.
So is it any wonder that the price flutters with the whims of the day traders instead of reaching its NAV? With no history of dividends, buybacks, and little hope of actually getting L$0.72 per share for your BNT, the market seems perfectly justified (to me) in withholding its Lindens from purchasing anything but a token amount of BNT, and so it seems to have progressed.
There has been some comparison of BNT to Microsoft (NYSE:MSFT) in the past. I can't link to it because I don't think it has been explicitly written down before, but trust me on this one. However, the differences are beginning to show between the technological juggernaut and BNT holdings:
- Microsoft has split nine (!!!) times in its history. BNT has split zero times.
- MSFT increased its stock price 273% (!!!) in its first year out of IPO. BNT has lost 76% to date (true, it hasn't been out a year yet, but at 3/4 of the way through the year, MSFT was still up about 160%).
- MSFT made no theories or announcements about how people were out to get them in their first year of operations (to my knowledge). BNT has made a few.
Sunday, January 6, 2008
Here We Grow
Although it's a few days into 2008, I'd like to announce my resolution for Second Chaos. I'd like to see this site grow into the multiple-author glory that I have envisioned for it. I'll need good authors (still accepting volunteers!), active and faithful readers, and a constant flow of new ideas to make that happen, but I believe it can be done. I'd like to see nearly-daily updates and 500 unique pageviews per week by the end of 2008. Check out how I'm doing here.
Want to help me out? Here are some things I could use, if you felt like giving SC a late present this season:
Want to help me out? Here are some things I could use, if you felt like giving SC a late present this season:
- Links: Technorati authority is built on links, as is search engine page returns. I'll be happy to return the favor in relevant posts.
- Comments and Feedback: Nothing makes for interesting discussion like reader opinions. Plus, it helps us here at SC know where to guide our articles.
- Ideas and Requests: I've already gotten a few, but I don't think the other authors have yet, and I'd love to have more. Keep 'em comin' - we'll tackle whatever you like.
- Referrals: Like what you see? Tell people to stop by.
Street Name
I would like to throw a new idea about the representation of shareholders in the SL Capital Markets out there. Ironically, this idea is currently in place and my suggestion is to remove some of it (how's that for backwards!). The idea is registered shareholders, and my suggestion is to add shares in street name to the mixture.
First, why? There has been longstanding debate between (long-term) investors and (short-term) day traders in the SL Capital Markets. I think both sides have their merits (and profitability) but its clear that the interests of the two parties are entirely different. A day trader probably isn't interested in long-term matters of the corporation, whereas an investor is very interested in those issues.
So what does adding street name do? If investors could voluntarily register their shares with a corporation, then that corporation would know it needs to pay attention to them because they're interested for the long haul. If the shares are in street name, then the company can be less concerned (not unconcerned, but less so) with these shares, because they will change hands frequently. As to voting, I think the street name share should abstain from votes, since that is basically why they are street name shares.
There should also be some (nominal) fee and some incentive to registering shares: the fee to show you're serious, the incentive to reap the benefits thereof. Perhaps a fee of L$10, but then you have the ability to sell share directly to the company during a buyback, or they refund part of your trading fees if you sell directly to the corporate treasury. Obviously this would require some changes to existing exchange coding, but I think there are benefits to be had as well.
Thoughts?
First, why? There has been longstanding debate between (long-term) investors and (short-term) day traders in the SL Capital Markets. I think both sides have their merits (and profitability) but its clear that the interests of the two parties are entirely different. A day trader probably isn't interested in long-term matters of the corporation, whereas an investor is very interested in those issues.
So what does adding street name do? If investors could voluntarily register their shares with a corporation, then that corporation would know it needs to pay attention to them because they're interested for the long haul. If the shares are in street name, then the company can be less concerned (not unconcerned, but less so) with these shares, because they will change hands frequently. As to voting, I think the street name share should abstain from votes, since that is basically why they are street name shares.
There should also be some (nominal) fee and some incentive to registering shares: the fee to show you're serious, the incentive to reap the benefits thereof. Perhaps a fee of L$10, but then you have the ability to sell share directly to the company during a buyback, or they refund part of your trading fees if you sell directly to the corporate treasury. Obviously this would require some changes to existing exchange coding, but I think there are benefits to be had as well.
Thoughts?
Thursday, January 3, 2008
Lessons in FM: Part VI - Rate of Return
Note: This is a continuation of the series Lessons in Financial Mathematics. Reading previous posts about this topic may aid in your understanding of this article. Note that this article is a direct continuation of Part V, and so reading that one would probably be a good idea.
Last week, I discussed my pseudo-accounting method of keeping track of the (Linden) dollar value of your gains and losses in an SL capital market. Now we turn to the topic of finding the rate of return earned over that month. I'll be using the same example as I came up with last time.
To be mathematically precise, the rate of return can become a very ugly equation very quickly. The reason is because you have to take into account all the cash flows in and out of your account at the times that they were taken. Basically, you're going to know your cash flows at time t (Ct), as well as the initial and final balances, and you have to solve something like this for i (and this is only for regular investment intervals!):
This gets really ugly really fast. Normally even financial calculators wind up using a numerical method like Newton's Method to figure this one out. (You can tell this is a hard calculation on a financial calculator because often the calculator will pause for a few seconds before spitting out the answer.)
It is time to introduce you all to the XIRR function. IRR stands for "internal rate of return," and is used to calculate that ugly polynomial I referred to up there. XIRR takes the form XIRR(values,dates,[guess]). "Values" are the cash flows (positive for coming in, negative for going out), "dates" are the dates that correspond to the cash flows, and "guess" is where the iterative method starts from (just use .10 or leave it blank). XIRR returns the decimal of your return. For example, a 15% return is expressed as .15, not 15% or 1.15.
However, XIRR is based on a 365 day period, and we were dealing with a one-month period. That means that it isn't discounting quite correctly. Therefore, I suggest adjusting (mathematically: transforming) the date values so that they correspond to a year-long period, rather than a month. To do this, we'll use the YEARFRAC function, which takes a start date and end date and produces the fraction of a (365-day) year that occurs between those two dates. The syntax is YEARFRAC(start_date,end_date). To complete the transformation we want to take that fraction of the year between our start date and our (1-month) dates, multiply that by 365 (number of days different), multiply that by 12 (to stretch it to 1 year instead of 1 month), and then add it to our original starting date (to transform it). The formula looks like this:
YEARFRAC(start_date,end_date) * 12 * 365 + start_date = transformed_date
We know it works because our last day of the month transforms to the day before 1 year after the first day. We started at 12/1/2007, and the last date is 11/30/2008. We win.
The only other adjustment is a small annoyance with XIRR, and that is that our cash flows need to have their signs reversed. Also, one of the balances (preferably the beginning one) needs to be the opposing sign of the other one. I've made the beginning one negative.
XIRR turns out negative for our example because we've only included the realized gains. To get a more complete picture, I've made another couple columns with L$1,500 in unrealized gains included in the ending balance (completely arbitrary, as all unrealized gains calculations are). This results in a much nicer-looking positive rate of return.
You can find the completed spreadsheet here. It's the same as last time, but with a new tab marked "Rate of Return" where you can find these calculations. Once again, I'll happily pass out free copies of the spreadsheet so that you all can read the formulas if you like. Just email me at guardian.market@gmail.com.
I think that takes care of my first reader request. I love to answer questions and help people understand topics, so keep 'em coming. Anyone else want to provide a challenge?
Last week, I discussed my pseudo-accounting method of keeping track of the (Linden) dollar value of your gains and losses in an SL capital market. Now we turn to the topic of finding the rate of return earned over that month. I'll be using the same example as I came up with last time.
To be mathematically precise, the rate of return can become a very ugly equation very quickly. The reason is because you have to take into account all the cash flows in and out of your account at the times that they were taken. Basically, you're going to know your cash flows at time t (Ct), as well as the initial and final balances, and you have to solve something like this for i (and this is only for regular investment intervals!):
Final = Initial * (1+i)t + C1 * (1+i)(n-1)/t - C2 * (1+i)(n-2)/t + ... + Cn-1 * (1+i)1/t
This gets really ugly really fast. Normally even financial calculators wind up using a numerical method like Newton's Method to figure this one out. (You can tell this is a hard calculation on a financial calculator because often the calculator will pause for a few seconds before spitting out the answer.)
That being said, there are several things which can make this calculation easier:
- Having no cash flows. That chops that ugly polynomial down to a simple exponential problem rather quickly.
- Assume all cash flows occur at a certain time (such as at the middle of the month). This, combined with a simple interest assumption, results in a very compact formula which can be very close to the real rate of return, or very far off (if you're unlucky).
- Put your cash flows at fixed intervals. This makes it more like an annuity calculation, discussed in Part II of my Lessons in FM.
- Harness the power of Excel.
It is time to introduce you all to the XIRR function. IRR stands for "internal rate of return," and is used to calculate that ugly polynomial I referred to up there. XIRR takes the form XIRR(values,dates,[guess]). "Values" are the cash flows (positive for coming in, negative for going out), "dates" are the dates that correspond to the cash flows, and "guess" is where the iterative method starts from (just use .10 or leave it blank). XIRR returns the decimal of your return. For example, a 15% return is expressed as .15, not 15% or 1.15.
However, XIRR is based on a 365 day period, and we were dealing with a one-month period. That means that it isn't discounting quite correctly. Therefore, I suggest adjusting (mathematically: transforming) the date values so that they correspond to a year-long period, rather than a month. To do this, we'll use the YEARFRAC function, which takes a start date and end date and produces the fraction of a (365-day) year that occurs between those two dates. The syntax is YEARFRAC(start_date,end_date). To complete the transformation we want to take that fraction of the year between our start date and our (1-month) dates, multiply that by 365 (number of days different), multiply that by 12 (to stretch it to 1 year instead of 1 month), and then add it to our original starting date (to transform it). The formula looks like this:
YEARFRAC(start_date,end_date) * 12 * 365 + start_date = transformed_date
We know it works because our last day of the month transforms to the day before 1 year after the first day. We started at 12/1/2007, and the last date is 11/30/2008. We win.
The only other adjustment is a small annoyance with XIRR, and that is that our cash flows need to have their signs reversed. Also, one of the balances (preferably the beginning one) needs to be the opposing sign of the other one. I've made the beginning one negative.
XIRR turns out negative for our example because we've only included the realized gains. To get a more complete picture, I've made another couple columns with L$1,500 in unrealized gains included in the ending balance (completely arbitrary, as all unrealized gains calculations are). This results in a much nicer-looking positive rate of return.
You can find the completed spreadsheet here. It's the same as last time, but with a new tab marked "Rate of Return" where you can find these calculations. Once again, I'll happily pass out free copies of the spreadsheet so that you all can read the formulas if you like. Just email me at guardian.market@gmail.com.
I think that takes care of my first reader request. I love to answer questions and help people understand topics, so keep 'em coming. Anyone else want to provide a challenge?
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