Tools

Using Spreadsheets – Graphing

Written by Kevin Smith

Graphing is one of the most important features of spreadsheets. When you need to present your findings, whether as a written report or a presentation, summarizing your data in graphs is the best way to quickly communicate large amounts of data.

This guide will walk through taking your raw portfolio data, making some simple calculations, and transforming the data into graphs that you can include in reports.

Line Graphs

Your Daily Portfolio Value

First, we want to make a line graph showing our daily portfolio value. Open your spreadsheet that has your daily portfolio values, it should look something like this:

Portfolio values are calculated at the end of the day when the market is closed and all your assets (Stocks and Mutual Funds strictly on this site) are summed together which shows your ending portfolio value.

To insert a basic line chart of your portfolio data, highlight your data and click “Insert” in the Office Ribbon, or “Charts” in Google Sheets:

And that is it! Your new chart is ready for display. You can even copy the chart and paste it in to Microsoft Word (if using Excel) or a Google Doc (if using Google Sheets) to make it part of a document, or paste it into an image editor to save it as an image to be used for any reports you might have it to use.

Microsoft Excel

Google Sheets

Portfolio Percent Changes

Next, we want to make a graph showing how much our portfolio has changed every day since the tournament has began. To do this, first we need to calculate the daily % change, instead of just our raw portfolio value.

Basic Calculations – Using Formulas

In the next column we will calculate our daily portfolio percentage change. First, in the next column, add the header “% Change”.

Now we need to make our calculation. To calculate the percent change each day, we want to take the difference between the most recent day’s value minus the day before, then divide that by the value of the day before.

Percentage Change = (Day 2’s Value – Day 1’s Value) / Day 1’s Value

To do this, in cell C3 we can do some operations to make the calculation for percentage change. To enter a formula, start by typing “=”. You can use the same symbols you use when writing on paper to write your formulas, but instead of writing each number, you can just select the cells.

To calculate the percent change we saw between day 1 and day 2, use the formula above in the C3 cell. It should look like this:

Now click on the bottom right corner of that cell and drag it to your last row with data, Excel will automatically copy the formula for each cell:

You now have your percentages! If you want them to display as percentages instead of whole numbers, click on “C” to select the entire column, then click the small percentage sign in the tools at the top of the page:

Selecting Certain Columns For Your Graph

Now we want to make a graph showing how our portfolio was changing each day, but if we try to do the same thing as before (selecting all the data and inserting a “Line Chart”, the graph doesn’t tell us very much:

This is because it is trying to show both the total portfolio value and the percentage change at the same time, but they are on a completely different scale!

To correct this, we need to change what data is showing. If you are using Excel, right click on your graph and click “Select Data”:

This is how we decide what data is showing in the graph. Items on the left side will make our lines, items on the right will make up the items that appear on the X axis (in this case, our Dates).

Uncheck “Portfolio Value”, then click OK to update your graph:

For Google Sheets, this is done similarly, right click on your graph and select “Data Range” (the letters for this example will be the same as Excel, C2:C6)

This is closer to what we’re looking for, but the axis labels (the dates) are right in the middle of the graph, making it hard to read.

Formatting Your Line Graph

Now we want to move the dates to the bottom of the graph (here they are along the “0” point of the Y axis).

To do this in Excel, right-click on the dates and select “Format Axis”:

A new menu will appear on the right side of the screen. Here, click “Labels”, then set the Label Position to “Low”.

The method is similar on Google Sheets as well, start by selecting “Axis” then “Horizontal” or “Vertical” Axis to edit them.

With this feature you change the axis titles and add different features to it.

Congratulations, your graph is now finished! You can now easily see which days your portfolio was doing great, and which days you made your losses.

Bar Charts and Pie Charts – Your Open Positions

Next we would like to make a bar chart showing how much of our current open positions is in each stock, ETF, or Mutual Fund.

Directions for Excel

First, open your spreadsheet with your Open Positions. It should look something like this:

Since we want to make a bar chart, we can only have two columns of data – one for the X axis, and one for the Y axis of our chart.

We want one column showing the symbol, and a second column showing how much it is worth. The “Total Cost” column is the current market value of these stocks, so that is the one we want to keep. However, we don’t want to delete the quantity and price, since we might want it later. Instead, select the columns you don’t want, and right-click their letter (A and C in this case). Then, select “Hide”.

Now the columns that we don’t want in our chart are hidden. We can always get them back later by going to “Format” -> “Visiblity” -> “Unhide Columns”.

Now select your data and insert a “Bar Chart” instead of a “Line Chart”:

Before you’re finished, your chart will say “Total Cost”. You can change this by clicking on “Total Cost” and editing to say whatever you would like (like “Portfolio Allocation”).

This graph is now finished, but you can also try changing the Chart Type to try to get a Pie Chart.

Switching Chart Types

Sometimes, our first chart type is not the best way to display our data. For example, a bar chart will show me how much of each symbol I am holding. A better choice might be a pie chart, which will show how much each symbol is as a percentage of my total holdings.

To change our bar chart to a pie chart, right click your graph and select “Change Chart Type”:

Next, find the “Pie” charts, and pick whichever chart you like the best.

Last, now we don’t know which piece of the pie represents which stock. To add this information, click your pie chart, then at the top of the page click “Design”. Then select any of the options to change how your pie chart looks.

Congratulations, you’ve converted your bar chart into a pie chart! This one should look almost the same as the one you have on the right side of your Open Positions page. You can now copy and paste these charts directly into your Word document, or save it as an image to use elsewhere.

Directions for Google Sheets

To create a Bar Graph, select “Insert” then “Chart”, the same as we did for our previous line charts.

When clicking this, one of the options in “Chart Editor”, will be “Chart Type”, there you can select the bar graph or pie chart.

In this section you will also need your Data Range, which will be the same as the previous example (Symbol and Total Cost). To edit the axis and other information, is the same method as the previous type.

The pie chart will look very similar to that on your Open Positions Page as well!

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Tools

Using Spreadsheets – Calculating Profit or Loss From Trades

Written by Kevin Smith

The most important reason you would want to use excel to track your stock portfolio is trying to calculate your profit and loss from each trade. To do this, open the spreadsheet with your transaction history. It should look something like this:

Tip: If you have not bought and then sold a stock, you can’t calculate how much profit you’ve made on the trade.

Simple Calculations

First, we want to change how the data is sorted so we can group all the trades of the same symbol together. Use the “Sort” tool to sort first by “Ticker”, next by “Date” (oldest to newest).

For DWTI and SPY, we haven’t ever “closed” our positions (selling a stock you bought, or covering a stock you short), so we cannot calculate a profit or loss. For now, hide those rows.

Now we’re ready to calculate! Lets start with the trade for S. This one is easy because the shares I sold equal the shares I bought. This means if we just add the “Total Amount”, it will tell us the exact profit or loss we made on the trade.

This does not work for UWTI, because I sold a different number of shares than I bought. This means that I need to first calculate the total cost of the shares I sold, then I can use that to determine my profit.

Different Buy/Sell Calculations

First: multiply your purchase price times the number of shares you sold:

Second: add this number to the “Total Amount” from when you sold your shares.

Now you have your profit or loss for this trade. Note: this is the method for if you bought more shares than you sold – if you bought shares at different prices, then sell them later, you’ll need to calculate your Average Cost to use in your calculation.

Average Cost Calculations

To calculate this, lets use the same example of UWTI shares and delete the rows of the S shares. Suppose we bought 11,620 shares on January 12^th, as we did above, but also bought 6000 shares on January 15^th for a different price at $2.5 per share. To calculate our profit or loss we would first have to calculate the Average Cost of the shares we bought. To do this, we need to add our total amounts for both purchases and divide that value by the total number of shares we bought. The calculation for this would be (24402+15000)/ (11620+6000), which would give us a value of $2.24. We can easily create a function on Excel or Google Sheets to calculate this for us. In this case, our function would be “=(G2+G3)/(C2+C3)” which should look something like this on Excel or Google Sheets:

Next, we subtract this Average Cost from the Average Sale price of $1.9 and multiply the value we get by the number of shares we sold. This will then give us our profit and loss for the trade. We will have to create another function for this onto cell G10. However, since our average cost value is already negative, we would add it on our function instead of subtracting. Our function should be “=(E4+G7) *-C4” which should give us a value of $-1681.04 (Loss). We also put a negative sign in front of our C4 value to represent a sale. Our final spreadsheet should look something like this:

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Tools

Using Spreadsheets – Calculating Your Daily Returns

Written by Kevin Smith

If you’ve been trading for a long period of time you might have been curious to know what your daily returns were. Excel and Google Sheets can help you efficiently calculate this in a simple way. Suppose we started trading on August 29^th, 2017. It is now September 7th and we would like to know our daily returns for our portfolio. First, we would look up our Historical portfolio values by going to our Dashboard, and clicking “View Historical Portfolio Values” next to our Portfolio Value Chart:

Once there, simply click on Historical Portfolio Values and a new window will pop up displaying the data. The page should look something like this:

You can either click the “Export” button to download this as a spreadsheet, or copy the data into your spreadsheet.

As mentioned in our Getting Some Data article, values may sometimes appear as “#####”. To fix this, you simply need to adjust the column widths.

Next, we add a heading for Daily Returns under column “C”. We can then create a function on Excel or Google Sheets to calculate each days’ return for us in dollars. Since we only started trading on August 29^th, we wouldn’t have any returns for that day and we can leave that cell blank. Instead, we would write the function onto the second cell under the column, cell C3, and drag it downwards from the bottom right of the cell to copy it onto the rest of the column. The function we would input is “=(B3-B2)”. It should look something like this on your Google spreadsheet or Excel:

The values we have calculated here are our daily returns in dollar amounts. If we wish, we can also find these amounts as a percentage. To do this, we would create another heading on column D and name it “Daily Returns %”. Then, we would click on the second cell under this column (Cell D3) and input the function “=(C3/B2) *100”. This should give us a value of 0.009%. To repeat this for the other dates, simply drag the 0.009% value downwards the same way we did for the dollar value. Google Sheets/Excel will then calculate the remaining values for us. We have now calculated our daily returns in a dollar amount and as a percentage. The final spreadsheet should look something like this:

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Tools

Using Spreadsheets – Importing and Formatting Data

Written by Kevin Smith

The first step in using any spreadsheet is getting some data! This tutorial will show you different ways to import some of your portfolio data into a spreadsheet and how to format it to make it easier to read.

Getting Data

The first step to using any spreadsheet is getting some data – once we have our data in our sheet, we will then start formatting it to make it easier to use.

Copy/Paste Method

The easiest way to import data is to just copy and paste it from a website or another source.

Getting Your Historical Portfolio Values

To get your old portfolio values, you can copy and paste them out of the Personal Finance Lab website. You can find these on the “Dashboard” page, next to your portfolio graph.

This will open up a small window showing what your portfolio value was for every day of the contest. Highlight the information you want, then right click and “Copy”.

Next, open a new blank spreadsheet and click cell A1. You can then right-click and “Paste” the data in. The column headings should be included too.

Adding Column Headings

If the column headings are not included, right-click the first row and select “Insert Row”. This will add a new row to the top of the spreadsheet where you can type in the column names. Google sheets gives you the option to add a row above or below the one you right clicked.

Now “Save” your file somewhere you can easily find it later, you’ve got some data!

Getting Historical Prices for Stocks

For this example, we want to get the historical prices for a stock, so we can look at how the price has been moving over time. First, create a new blank spreadsheet in Excel or Google Sheets. We will use Sprint stock (symbol: S). Go to the quotes page and search for S, then click “Price History” on the right side of the page:

Next, change the “Start” and “End” dates to the time you want to look at. Once you load the historical prices, highlight everything from “Date” to the last number under “Adj. Close” (it should look like this):

Now copy the data, select cell A1 in your blank spreadsheet, and paste.

Congratulations, we have now imported some data into our spreadsheet! You can now save it for future use. The data is a bit messy; we will look at formatting later.

Export Method

Sometimes, websites will make it easy for you to export data directly to your spreadsheet without copy/paste. If an export option is available, this is going to work better, since it will require less formatting later.

If we look back at the Historical Prices, you can see that there is also a “Download” button at the top of the table:

This will download a spreadsheet you can just open directly – you can also see the data is already easier to read and better formatted, which will save us time later.

Copying Between Spreadsheets

You can also export your portfolio data from most places on the site, but for this example we will use the full Account Export from the My Contests page. This will download one big spreadsheet showing your account balances, trades, open positions, and more.

For each individual report, you can also use the “Export” button at the top of every table, which we will cover later on.

Once you download the spreadsheet, you can open it to see the available data:

The top red square is your transaction history, the bottom red square is your Open Positions. To use this data, you will need to open a new blank spreadsheet and copy these boxes (just like we did above) from one spreadsheet to another.

Start by taking your “Transaction History”, copying the data, and pasting it into a new spreadsheet.

To start using this data, we will need to look at formatting to make it easier to read.

Formatting Your Data

Now that we have a few saved spreadsheets, we can look at formatting the data to make it easy to read and use later.

Changing Data Order

If we look at the spreadsheets we have saved for our Historical Portfolio Values, it is the exact opposite of what we have for our Historical Prices.

To get them in the same order, we will want to open up our Historical Prices spreadsheet, and order the data from “Oldest” to “Newest”.

We will use the “Sort” function with Excel, or the “Data” function for Google Sheets.

We can now choose what we want to sort by, and how to sort it. If you click the drop-down menu under “Sort By”, excel lists all the column headings it detects (select “Date “). Next, under “Order”, we want “Oldest to Newest “:

Now your data should be in the same order as your portfolio values from earlier.

Changing Column Width

Next, you’ll notice that some of your data appears just as “########”. This is not because there is an error, the number is just too big to fit in the width of our cell. To fix this, we can increase and decrease the widths of our cells by dragging the boundaries between the rows and columns:

Tip: if you double click these borders, the cell to the left will automatically adjust its width to fit the data in it.

If you want to automatically adjust all your cells at once, at the top menu click “Format”, and “Auto Fit Column Width”:

Once you’ve adjusted your volume column, everything should be visible!

Removing Columns

If we want to use this data for making a graph, we will not need all of the data in the sheet. We really only need the “Date” and “Closing Price”. To keep it easy to read, we will delete some of the extra data.

If you just highlight the data you don’t need and press “Delete”, you will end up with a bunch of blank cells, which is not very useful when trying to read the table:

Instead, click on “B” and drag all the way to “H” to select the full columns:

Now right-click and click “Delete”, and the entire rows will disappear. Now the Close will be your new column B, with no more empty space. You now have your historical price data, so save this excel file so you can use it later.

Unmerging Cells

Now let’s go back to our Transaction History spreadsheet. With this sheet, we cannot do many of the basic operations because there are some “Merged Cells”. Merged Cells can be used for formatting and presentation, but for now it is just getting in our way.

This is the case with the Ticker, Commission, and Total Amount cells. We need to “unmerge” these cells to make our data usable.

To do this, select all your data, then on the main menu bar click on “Merge and Center “. Under this, click “Unmerge Cells”. On Google Sheets, this can be done by clicking on the “Format” tab in the navigation bar and then clicking on “Text Wrapping” and then “Clip”.

Putting It All Together

Now that we have our data all in their own cells, we can start deleting the rows and columns we don’t need. For example, rows 2 and 3 have our beginning cash, which we don’t need in our transaction history. Columns E and H are now blank, so we can get rid of those too. Once you delete the rows and columns you don’t need, you can also autofit the row width to make the “date” visible.

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Economics

Gross Domestic Product

Written by Kevin Smith

In Economics, “Gross Domestic Product” is the one statistic to rule them all – a measure of the total size of an economy.

Definition

The “Gross Domestic Product” of a country is the total value of all finished goods and services that were produced in a given year. In other words, this is the total economic output. GDP is used to measure the total size of an economy, and therefore how much the economy has grown (or shrunk) in a year.

Calculating GDP

There are a few ways to calculate GDP, but the easiest measurement looks at consumption, investment, government activity, and net exports.

Consumption – how many goods and services were purchased by households each year (this doesn’t include business purchases)
Investment – how much money was saved, or otherwise invested each year (this does include business investments)
Government Activity – how much money the government spent each year
Net Exports – How much the country imported vs exported each year

Remember: GDP is supposed to calculate the production in one country each year. If there is household consumption of imported goods, we need to subtract it. If goods are exported and consumed in another country, we need to add it.

Net Exports = Exports – Imports

This means the final calculation for Nominal GDP is:

GDP = Consumption + Investment + Government Spending + Net Exports

Nominal VS Real GDP

Calculating GDP for one year is pretty easy, but GDP numbers are most useful when we compare them from year to year. The only problem is that prices aren’t the same every year – we can’t increase the size of our economy just by doubling all the prices. This means once we calculate the “Nominal” (not adjusted for inflation) GDP above, we need to translate this into a “Real” (adjusted for inflation) GDP to use it for research.

Real GDP = Nominal GDP x (1 – Inflation)

Per Capita GDP

Economists usually want to go one step further – instead of just calculating the size of the economy, we really want to know how much is being produced per worker. This is called “Per Capita” GDP – it lets us see how much more or less each country produces compared to another.

For example, if you look at the GDP of China vs Switzerland, it looks like China is much richer:

Source: World Bank https://data.worldbank.org

However, if we adjust this to look at the output per worker, it shows a much different story:

Government policy is not usually focused on increasing the total GDP, but increasing the Per Capita GDP.

What Causes GDP To Increase?

GDP increases when output increases. When we look at how much a country could potentially produce in a given year, if its resources were all being utilized to the maximum, we would consider:

The total population (Quantity of Workers) – how many workers are available?
The skill level of the population (Quality of Workers) – how well are the workers trained? Are there a lot of college graduates and skilled tradesmen, or mostly farmers working by hand?
Quantity of available capital – how many factories, machines, and tools are available? Having a huge population doesn’t help if they can’t be given the tools to do valuable work!
Quality of available capital – how good are the machines and tools available? Are they fairly new and well working, or are they old and out of date?
Quantity of natural resources – how big is the country? Is there plenty of farmland and places to mine valuable minerals?
Quality of natural resources – how easy is it to get those natural resources? For example, an oil field near a major city in Texas is much easier to drill and exploit than an oil field in the middle of Alaska
Level of Technology – how much research and development is going on? How likely is it that even better tools and machines will be produced next year, and how fast can they be produced?
Legal and Cultural Institutions – how important is economic growth to the country? Does the government make it possible for new business to start easily, or is there a lot of red tape?

There isn’t much a country can do about their total population or the available natural resources, but governments do focus on improving the rest of these factors to try to improve economic growth.

Leapfrog Effects

Thanks to international trade, GDP tends to grow much faster in countries with lower per-capita GDP. This is because of something called the “Leapfrog Effect”.

Think of it this way: England spent over a hundred years and the equivalent of billions of dollars building railroads all over their country to help speed up trade. Every year, companies would spend millions to make small improvements to the rail engine technology. This slowly improved their technology, quantity, and quality of capital goods.

In contrast, China has been rapidly expanding their rail network starting in the 1950’s. This means when they first started building their rail networks, they were able to just buy the newest, most up-to-date trains from England, “leap-frogging” a hundred years of research and development to get the same capital goods and level of technology.

This can be risky for the country with the lower per capita GDP. In China’s case, the government mandated that all households needed to make huge cuts to their consumption in order to put all of their existing economic output towards investment to buy the new machines. Since the workers were poor to start with, there were many deaths from starvation. For other countries, they typically take out loans from international banks to pay for the new machines. This is less hard on the workers immediately, but it means they will be saddled with debt until they can earn enough to pay back the loans.

Almost all developing countries accept some of these risks, and use the leapfrog effect to rapidly increase technology, and their GDP with it.

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Admin Guides

Teacher Introduction Webinars

Written by admin

See our introduction webinar to walk through every aspect of creating your class stock, adding assignments, viewing reports, and much more.

Also check our webinar in managing your class Budget Game, including how the game works, class set-up, and teacher reports.

Accounting

The Accounting Cycle

Written by Kyle Maclay

The accounting cycle is a series of steps that businesses take to track transactions and consolidate financial information over a specific accounting period (month, quarter, year). The end result of the accounting cycle is the production of accurate financial statements for that period and preparedness for the next accounting period. We will examine the steps involved in the accounting cycle, which are: (1) identifying transactions, (2) recording transactions, (3) posting journal entries to the general ledger, (4) creating an unadjusted trial balance, (5) preparing adjusting entries, (6) creating an adjusted trial balance, (7) preparing financial statements, (8) preparing closing entries, and (9) preparing the post-closing trial balance.

Identify transactions

Transactions involve buying or selling something and can be defined as ‘the act of conducting business.’ This could involve the exchange or transfer of goods, services, or funds. When a transaction occurs, it is recorded in the company’s accounting system, in the form of a journal entry. However, the transaction must first be identified; for example, if a company purchases machinery, they must add a new asset to the accounting equation.

Identify transactions – example

On January 1, 2018, Martin Company issued 5,000 shares of common stock for cash at $20 per share. The company also identified the following transactions in January:

Failing to identify transactions would cause the subsequent steps in the accounting cycle to be inaccurate. Therefore, all transactions must be identified and analyzed or else we will have a flawed financial reporting process.

Effects of Transactions on the Accounting Equation

Each new transaction changes a company’s financial condition and impacts certain asset, liability, and/or equity accounts. The accounting equation is written below:

The accounting equation can be written as:

Assets = Liabilities + Shareholder Equity

The accounting equation will always hold true – if it does not, there is a problem. Properly recorded transactions will keep the accounting equation balanced. This is why it is important to not just identify, but also analyze transactions and record them accurately.

Record transactions

Transactions are first recorded in an accounting system in the form of journal entries. Each transaction must be listed in the appropriate journal and maintained in the order that they occurred. Each journal entry consists of the following information:

The account(s) and amount(s) to be debited
The account(s) and amount(s) to be credited
The date of the transaction
An explanation of the transaction

The following example will demonstrate the recording of the transactions we identified in the first step of the accounting cycle.

Record transactions – example

Each transaction has a debit and a credit entry, is listed in chronological order, and includes a brief description of the transaction itself. Now that each transaction has been properly recorded in the general journal, we are ready to post the journal entries to the general ledger.

Post journal entries to ledger accounts

The general ledger is used to create a company’s financial statements. Once a transaction has been journalized, it is eventually posted (or transferred) to the general ledger. Having a complete listing of transactions in the general ledger will allow us to create the unadjusted trial balance and continue with the steps in the accounting cycle. The following example will demonstrate how we post journal entries from the previous step to the general ledger.

Post journal entries to ledger accounts – example

The ending balance in these ledger accounts (in grey) will be used to create the unadjusted trial balance in the next step. Remember: if the trial balance does not balance, something is wrong!

Prepare unadjusted trial balance

At the end of an accounting period, an unadjusted trial balance is created to verify that the total debit entries equal the total credit entries. The unadjusted trial balance is a list of accounts and their balances before any adjusting entries are made to create the financial statements. We will create the unadjusted trial balance by simply entering the ending balances in the ledger accounts from the previous step and adding up the debits and credits to see if they balance.

Prepare unadjusted trial balance – example

Looks good! Everything balances and this prepares us to make any necessary adjusting entries to create the adjusted trial balance.

Prepare adjusting entries

Adjusting entries are made at the end of an accounting period (year, quarter, month). These entries alter the final balances of certain ledger accounts to reflect the revenues earned and expenses incurred during an accounting period. This ensures that we comply with the accrual concept of accounting.

Prepare adjusting entries – example

Information for Adjusting Entries:

Office supplies with an original cost of $5,000 were unused at the end of the period. Office supplies having an original cost of $17,000 are shown on the unadjusted trial balance.
The machinery costing $50,000 has a useful life of 6 years and an estimated salvage value of $10,000. The straight-line depreciation method is used.

These adjusting entries will be used to adjust the trial balance to reflect changes that need to be made at the end of the accounting period.

Prepare an adjusted trial balance

After adjusting entries have been made, companies prepare an adjusted trial balance. The adjusted trial balance shows the balance of all accounts and includes the adjustments made at the end of the accounting period. In the following example, we will apply the adjusting entries made in the prior step to our unadjusted trial balance.

Prepare an adjusted trial balance – example

As you can see, ‘Supplies Expense’ increased by $12,000 and ‘Office Supplies’ decreased by $12,000 to reflect an expense we incurred in January, but had not yet recorded. ‘Depreciation Expense’ increased by $556 and ‘Accumulated Depreciation’ increase by $556.

Prepare financial statements

Financial statements can be prepared from the adjusted trial balance. Financial statements provide reporting on a company’s financial results, financial condition, and cash flows.

Prepare financial statements – example

Income Statement

Balance Sheet

Prepare closing entries

In the closing phase of the accounting cycle, the balances of temporary accounts are brought to zero to prepare for the next accounting period. In this step, temporary accounts are essentially ‘emptied out’ into permanent accounts.

Prepare closing entries – example

Prepare a post-closing trial balance

The post-closing trial balance eliminates all temporary accounts and leaves only real (or ‘permanent’) accounts. This balances allows us to check our work and determine that we journalized and posted the closing entries properly. The post-closing trial balances can be seen in ‘Step 7’ above as one of the financial statements we created.

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Blog

How Does PersonalFinanceLab.com Align to JumpStart’s Personal Finance Standards?

Written by Mark Brookshire

There are several popular stock market games available to high school teachers; but only PersonalFinanceLab.com embeds curriculum specifically aligned to the JumpStart Personal Finance Standards. We supply all the material and lesson plans to offer finance in the classroom.

What is PersonalFinanceLab.com?

At the core of PersonalFinanceLab.com is a customizable stock market game for students that allows teachers to create their own custom experiences. Teachers create their own stock market contest for each class by choosing the trading period dates, the security types they want to allow their students to trade, the diversification rules, and other trading parameters. The eligible security types include U.S. stocks, bonds, mutual funds, ETFs, options and even cryptocurrencies. The trading is in real-time, and students’ portfolios and class rankings are updated every minute the markets are open. The virtual trading technology that powers PersonalFinanceLab.com is from Stock-Trak Inc., the leading provider of educational stock market simulations to the K12 and university markets since 1990.

FINALLY – A Stock Market Game with Built-in Personal Finance Curriculum Aligned To Standards

What makes PersonalFinanceLab.com so unique is that after teachers create their custom stock market contest, they also create their customized assignments by choosing the lessons from the site’s library of over 300 built-in lessons, activities, calculators, etc. These lessons are embedded into the site so that when students login, they see both their stock portfolio performance and their progress through the assigned lessons. Finally–Students are forced to work thru curriculum as they research and trade stocks!

Personal Finance Curriculum Overview

Teaching Personal Finance is tough, but we have your back. The Personal Finance curriculum built into PersonalFinanceLab.com is focused on the JumpStart standards. All 300 activities are carefully designed to meet both State and National standards, and can be cherry-picked to meet your specific class’s learning objectives.

Jumpstart financial literacy - finance in the classroom

To jumpstart financial literacy, Click Here for the complete lessons and how they align to these standards.

If you have questions about how PersonalFinanceLab.com can jumpstart financial literacy for high school students, feel free to call 1-800-786-8725 9:30 to 5:00 ET.

To request more information, please complete this form: https://personalfinancelab.com/get-personal-finance-lab/

Blog, Press

High School Personal Finance Labs

Written by David Cragg

Press Release: Quebec, Canada – WEBWIRE – Wednesday, August 8, 2018

Stock-Trak Announces Launch of PersonalFinanceLab.com. This site offers an Online High School Personal Finance Lab. There is a new trend sweeping through magnet schools, CTE programs, and business academies. These schools are converting ordinary classrooms into an exciting and engaging learning environment. They are called a “Personal Finance Lab.”

“High schools have Biology lab. Why don’t they have Personal Finance labs?” is the new rallying cry of Mark Brookshire, Founder, and CEO of Stock-Trak Inc. “Every student will one day have a job, pay taxes, live on a budget, need insurance, use a credit card, and save and invest for retirement. Let’s get students excited to learn about financial literacy. Let’s teach these subjects in an exciting and engaging classroom setting that makes them want to learn.”

Mr. Brookshire has been traveling around the country attending various educational conferences. He promotes his vision for high school Personal Finance Labs. He uses the financial literacy for high school students lesson plans available on PersonalFinanceLab.com to integrate a stock market game with stock market lessons. His idea for these Personal Finance Labs includes scrolling stock tickers, LCD screens, educational wall posters, and a stock market simulation. They include a built-in curriculum from PersonalFinanceLab.com.

“The scrolling stock tickers and the LCD screens that display current stock prices and headline news provide the classroom with that exciting Wall Street feel, and the curriculum and stock simulation of our PersonalFinanceLab.com website provide an engaging learning experience that pulls it all together,” Mr. Brookshire says”

Stock-Trak is the leading provider of educational stock market simulations to the high school and college market. Some universities have built “trading rooms” that use one of Stock-Trak’s virtual trading applications to help teach the Investments and Portfolio Management classes. Unfortunately, very few high schools had moved in that direction. There is a growing emphasis on high school financial literacy classes in many states. Stock-Trak has seen a dramatic increase in high schools using its virtual trading sites (HowTheMarketWorks.com, NationalSMS.com). Classes that typically adopt include Personal Finance, Economics, Business and Social Studies classes.

“More and more teachers have been asking us to integrate Economics, Business, and Personal Finance Curriculum into our virtual trading site. They have also asked how they can get the students more excited about such an important topic” says Mr. Brookshire. “That’s how our Personal Finance Lab concept was conceived. We designed our newest website, PersonalFinanceLab.com, to fill the void and address that need.”

For more information about financial literacy lesson plans using a stock market simulation for students, please visit PersonalFinanceLab.com.

Blog

How easy is PersonalFinanceLab to use?

Written by Kevin Smith

Excellent, authoritative resources for your classroom. Our site allows teachers to use a real-time stock market game to teach personal finance basics. It is only helpful if teachers can find the time to master it as part of their lesson plans.

When we designed Personal Finance Lab, we wanted to make it the easiest-to-use resource to teach personal finance basics. You can get your class up and running in less than 10 minutes. Just three easy steps!

Step 1: Create a Class Contest

The core of Personal Finance Lab is the stock market game for students. When you log in with your teacher account, you’ll be taken straight to the Class Contest Creation page. Here you’ll choose some of the rules for your class portfolios, like:

How much cash should my students get?
Can they short sell or day trade?
Can they borrow money?
What types of investments can they make (just stocks, or also things like mutual funds, bonds, options, and cryptocurrencies)?

Your class is not locked into anyone else – so you pick the rules that work best for your class. This means you select the start dates and end dates that work for you. The more comfortable you get managing your class, the more customization you can do! If it is your first time, we keep it simple. Every rule has a default setting that we find works best with most classes.

If you aren’t sure about anything, we built in both an FAQ explaining each rule, and a live chat with our support team right into the page! The best part is that nothing is set in stone. This is your class with your rules. If you want to change some settings later, you can with just a click of a button!

If you want to see a detailed guide on all the different class rules, click here!

Step 2: Create Your Assignments

Once you set your class rules, jump right in by adding “Assignments.” This is the list of the integrated activities you want your students to complete each week. We make this super simple. Choose what you want your students to do, set a start date and due date, and that’s it!

For your first assignment we take out the guesswork. The first ten tasks (the “Investing Fundamentals”) is what your students need to know. This is a simple combination of articles, videos, and infographics explaining the basics of what it means to have a portfolio, and how to make their first trades.

For your next assignments, just scroll down the list and check off the items that you plan on covering in class this week. You can queue up several assignments in advance, or just set them up each week! All of the tasks available align with both State and National standards (and we list which ones), making it super simple to sync up with your class syllabus.

If you want a detailed guide of setting up assignments, click here!

Step 3: Watch Your Students Compete And Learn

Once your class is set up, you’ll get a link you can give your students. They will choose their username and password, and off to the races! As the teacher, you get a birds-eye view of all their activities. You can see every student’s trade, current holdings, progress on their assignments, and even what the most popular trades across your classes are.

It also keeps growing – you will have over $1,800,000 by the time you turn 65 – letting you spend over a hundred thousand dollars per year while your investments continue to grow in retirement!

PFin Keys To Success

Investing In Bonds

Written by Kevin Smith

Bonds are a loan you can make to governments, and they will pay you back regular interest payments. At the end of the bond term, you will also get back the loan amount.

Bonds are very low-risk investments, but also tend to be very low reward (typically not much more inflation). These are a great way to invest if you are unsure about the stock and commodities markets.

PFin Keys To Success

Investing In ETFs

Written by Kevin Smith

Exchange Traded Funds (or ETFs) are investment funds with a lot in common with mutual funds. Instead of being managed by a professional Fund Manager, ETFs are designed to replicate the movement of some other index, such as the S&P 500, or follow the price of oil. These can be used both to diversify a portfolio and to invest in things like commodities, which do not normally trade on the stock exchange.

ETFs are a good way to invest in a broad range of investments all at once, such as broadly investing in Biotech stocks. They can also be used to “Go Short” on a broad index, or even use a Leveraged ETF to double the gains (or losses) of whatever it is tracking!

PFin Keys To Success

Written by Kevin Smith

A “Spending Plan” is similar to a budget, but a bit easier to manage and follow. With a spending plan, you will not try to allocate every dollar of your income to either saving or spending, but set a general guide on how much you usually spend for different things.

By setting aside your savings before even looking at your other expenses, most people find it much simpler to stay under budget!

PFin Keys To Success

Do I Need A Budget?

Written by Kevin Smith

If you have income and expenses, you need a budget! Budgets are living tools that you can use to visualize how much you spend every month, and are essential to setting and meeting your savings goals.

Equities Trading FAQ, H-M

Long Stock

Written by Kevin Smith

Long Stock

What is a long stock?

A long stock is an expression used when you own shares of a company. It represents a claim on the company’s assets and earnings. As you increase your holdings of a stock, your ownership stake in the company increases. Words such as “shares”, “equity” and “stock” all mean the same thing. In the world of trading, being long on a stock means that you currently purchased shares of a company and have it part of your open positions.

What are its components? Can you show me how to long a stock on a trading platform?

The components of a long stock are quite simple. You simply need to perform a buy order to open a long position on a stock:

When and why should I have a long stock?

You should have a long stock when you expect the stock price to go up. In other words, you have a bullish position on the security.

What does it look like graphically? What is the payoff and profit graph?

Equities Trading FAQ, N-T

What Is A Short Stock?

Written by Kevin Smith

Short Stock

What is a short stock?

A short stock is an expression used when you sold shares of a company that you did not own beforehand. Let’s say you expect a stock’s price to drop. Shorting a stock would involve a strategy where you borrow shares from another party (usually a broker) and sell it on the market. Borrowing from a third party implies that you will have margin requirements, which is cash set aside for the borrower’s protection on the asset. You would close this position by buying back the quantity of shares at a lower price, return the shares to the broker and pocket the difference as a gain (or a loss, if you purchased the stock at a higher price). Words such as “shares”, “equity” and “stock” all mean the same thing.

In the world of trading, being short on a stock means that you currently sold shares of a company and have a negative number of shares in your open positions. You would eventually bring back this number to zero by covering (buying back) these shares in the future.

What are its components? Can you show me how to short a stock?

The components of a short stock are quite simple. You simply need to perform a short sell order to open a short position on a stock:

When and why should I have a short stock?

You should short sell a stock when you expect the stock price to go down. In other words, you have a bearish position on the security.

What does it look like graphically? What is the payoff and profit graph?

[qsm quiz=183]

A -G, Options, Options Trading FAQ

Butterfly Spreads

Written by Bavan Arumugam

A butterfly is a volatility bet that the trader can implement to protect against large fluctuations, or to gain on volatility. You will notice that a butterfly is almost like a straddle, with a difference in the edges. The traders can add additional contracts to his/her strategy to reduce the risk of large losses or gains for more protection. A butterfly can be executed in different ways: with puts only, calls only, or a mix of both.

What are its components?

A long butterfly can be created in three ways:

Butterfly with puts only
- Buy Put at strike price 1
- 2 x Sell Put at strike price 2
- Buy Put at strike price 3
Butterfly with calls only
- Buy Call at strike price 1
- 2 x Sell Call at the strike price 2
- Buy Call at strike price 3
Butterfly with puts and calls
- Buy Put at strike price 1
- Sell Put at strike price 2
- Sell Call at strike price 2
- Buy Call at strike price 3
(*A short butterfly can be created by implementing the reverse strategies above)

When and why should I have a butterfly?

You should have a butterfly if you expect to see a lot of fluctuation in the underlying asset’s price. Creating a butterfly does not infer that you have a specific view on the stock. It simply implies that the trader expects a lot of volatility and executed a strategy to gain something from it. You can create a short butterfly if you do not expect any fluctuations.

What does it look like graphically? What is the payoff and profit graph?

What is the break-even point?

The break-even point of a butterfly can be defined by finding the stock price where the butterfly generates a zero-dollar profit. By adding all contracts and equating it to zero, you should solve for ST. However, there is a possibility where a region of stock prices can break-even. To find this region, you should create scenarios to define the payoffs. For example, the payoff when ST<30, 30<ST<40, 40<ST<50 and 50<ST.

N-T, Options, Options Trading FAQ

Strangle Spread

Written by Bavan Arumugam

A strangle is a volatility bet where you simultaneously long a call at Strike Price 2 and long a put at Strike Price 1. You will notice that the difference with a straddle is the difference strike price for the long call. By buying a call with a higher strike price, you are buying a cheaper call, thus reducing the transaction costs.

A strangle has payoff/profit that is somewhat similar to a straddle. The difference resides that there is a region between strike price 1 and strike price 2 where the payoff/profit is stable. Traders can also bet again volatility by shorting a call at Strike Price 2 and selling a put at Strike Price 1.

What are its components?

A long straddle has two components:

Long put at strike price 1
Long call at strike price 2

*(A short straddle can be created by shorting a call at strike price 2 and shorting a put at strike price 1)

When and why should I have a strangle?

You should have a strangle if you expect to see a lot of fluctuation in the underlying asset’s price. Creating a strangle does not infer that you have a specific view on the stock. It simply implies that the trader expects a lot of volatility and executed a strategy to gain something from it.

What is the payoff and profit graph?

What is the break-even point?

The break-even point of a strangle can be defined by finding the stock price where the strangle generates a zero-dollar profit. By adding all contracts and equating it to zero, you should solve for ST. However, there is a possibility where a region of stock prices can break-even. To find those two points, you should create scenarios to define the payoffs. For example, the payoff when ST<40, 40<ST<50 and 50<ST.

N-T, Options, Options Trading FAQ

Straddle

Written by Bavan Arumugam

A straddle is a volatility bet where you simultaneously long a call at Strike Price 1 and long a put at Strike Price 1. This creates a triangular shaped payoff and profit graph where the reward is based on the volatility of the stock. Traders can also bet against volatility by shorting a call at Strike Price 1 and selling a put at Strike Price 1.

What are its components?

A long straddle has two components:

Long put at strike price 1
Long call at strike price 1

*(A short straddle can be created by short both the call and put at strike price 1)

When and why should I have a straddle?

You should have a straddle if you expect to see a lot of fluctuation in the underlying asset’s price. Creating a straddle does not infer that you have a specific view on the stock. It simply implies that the trader expects a lot of volatility and executed a strategy to gain something from it.

What is the payoff and profit graph?

What is the break-even point?

The break-even point of a straddle can be defined by finding the stock price where the straddle generates a zero-dollar profit. By adding all contracts and equating it to zero, you should solve for ST. However, there is a possibility where there are two stock prices that can break-even. To find those two points, you should create scenarios to define the payoffs. For example, the payoff when ST<40 and 40<ST.

A -G, Options, Options Trading FAQ

Collar Spreads

Written by Bavan Arumugam

A bullish collar is a protection strategy where you simultaneously buy a call at strike price 1 and sell a put at strike price 2. This strategy is for investors who has a bullish perception on the underlying asset. We can also create a “bearish” collar by simultaneously buying a put at strike price 1 and selling a call at strike price 2.

What are its components?

A “bearish collar” has two components:

Buy put at strike price 1
Short call at strike price 2

A “bullish collar” has two components:

Buy call at strike price 1
Short put at strike price 2

When and why should I have a collar?

You should have a collar if you strongly believe that the stock price will either be bullish or bearish. Graphically, a collar looks like a stock’s graphs, but with a width where the payoff is stable. By shorting the second option contract, you are covering your options costs for the first option contract. However, should the price go in the opposite direction, you will have a large loss.

What is the payoff and profit graph?

What is the break-even point?

The break-even point of a collar spread can be defined by finding the stock price where the spread generates a zero-dollar profit. By adding all contracts and equating it to zero, you should solve for ST. However, there is a possibility where there is a range of stock prices that can break-even. To find that range, you should create scenarios to define the payoffs. For example, the payoff when ST<30, 30<ST<40, 40<ST.

N-T, Options, Options Trading FAQ

Ratio Strategy

Written by Bavan Arumugam

A ratio is an option strategy that is created by having X amount of call options at Strike Price 1 and shorting Y amount of call options at Strike Price 2. By creating a ratio, you are creating an option strategy where you can reduce your total option costs by shorting more call options are a higher strike price.

What are its components?

A ratio strategy has four components:

X amount of long call options
Y amount of short call options

When and why should I have a ratio strategy?

You should have a ratio strategy if you have a bullish view on the performance of the underlying asset. By shorting Y amount of call options, you are consistently reducing your option costs and eventually creating a zero-cost strategy. The ratio can be adjusted based on the investor’s perception of asset. The same concept can be applied with puts.

What is the payoff and profit graph?

What is the break-even point?

The break-even point of a ratio strategy can be defined by finding the stock price where the bear spread generates a zero-dollar profit. By adding all contracts and equating it to zero, you should solve for ST. There is a possibility where two stock prices can break-even. To find both points, you should create scenarios to define the payoffs. For example, the payoff when ST<30, 30<ST<40, 40<ST.

A -G, Options, Options Trading FAQ

Box Spreads

Written by Bavan Arumugam

A box spread is an option strategy that is created by combining the components of the bull spread and the bear spread. By creating a box spread, you are creating a neutral riskless position that generates a return like a bond. A box spread can be used to borrow or lend funds.

What are its components?

A box spread has four components:

Long call at strike price 1
Short call at strike price 2
Short put at strike price 1
Long put at strike price 2

When and why should I have a bear spread?

You should have a box spread if you have a neutral view on the stock’s performance. The box spread will give the trader the ability to lend or borrow cash using a box spread.

What is the payoff and profit graph?

What is the break-even point?

Since the box spread has a payoff and profit structure like a bond, it does not have a break-even point.

A -G, Options, Options Trading FAQ

Bear Spread

Written by Bavan Arumugam

A bear spread is a strategy where you simultaneously sell a put at Strike Price 1, and buy a put at Strike Price 2. Recall that users will pocket the premium should the option not be exercised. By selling a put with a lower strike price, users can reduce their total transaction costs and create a strategy that can generate a fixed income like in a bull spread.

What are its components?

A bear spread has two components:

Short a put at strike price 1
Buy a put at strike price 2
(*A bear spread can also be created with puts)

When and why should I have a bear spread?

You should have a bear spread if you are moderately bearish on a stock and wish to enter a bearish position with protection. By having a long put, you will have a bearish position on a stock and a protection should the stock increase. This position entails that you will pay a premium, where the short option comes in play and reduces your costs. By doing this additional transaction, you are willing to reduce your gains for a lower transaction costs and a steady income stream once the stock performs at a price below strike price 1.

What is the payoff and profit graph?

What is the break-even point?

The break-even point of a bear spread can be defined by finding the stock price where the bear spread generates a zero-dollar profit. By adding both puts together and equating it to zero, you should solve for ST.

A -G, Options, Options Trading FAQ

Bull Spreads

Written by Bavan Arumugam

A bull spread is a strategy where you simultaneously buy a long call at Strike Price 1, and sell a call for Strike Price 2. Recall that users will pocket the premium should the option not be exercised. By selling a call with a higher strike price, users can reduce their total transaction costs and create a strategy that can generate a fixed income like in a bull spread.

What are its components?

A bull spread has two components:

Long call at strike price 1
Short call at strike price 2
(*A bull spread can also be created with puts)

When and why should I have a bull spread?

You should have a bull spread if you are moderately bullish on a stock and wish to enter a bullish position with protection. By having a long call, you will have a bullish position on a stock and have a protection should the stock decrease. This position entails that you will pay a premium, where the short option comes in play and reduces your costs. By doing this additional transaction, you are willing to reduce your gains for a lower transaction costs and a steady income stream once the stock performs at a price above strike price 2.

What is the payoff and profit graph?

What is the break-even point?

The break-even point of a bull spread can be defined by finding the stock price where the bull spread generates a zero-dollar profit. By adding both calls together and equating it to zero, you should solve for ST.

A -G, Options, Options Trading FAQ

Cap

Written by Bavan Arumugam

A cap is an options protection strategy where you simultaneously have a short position on a stock and a long call for the same underlying asset. Adding a long call to your open position means that you are obligated to buy your stock at the strike price. However, you already have a short position on the asset, which means this call option will help you close your position on the stock by buying back the shares at a fixed price. You will gain the difference from the short stock and the long call. The combination of those two products creates a payoff that is like a long put. However, the profit is not the same since you spent more on a cap versus a put option.

What are its components?

A cap has two components:

Short Stock
Long Call

When and why should I have a cap?

You should have a cap if you are bearish on a stock and wish to have an extra protection in case the price of the stock goes up. By adding a long call to your long position, you are willing to reduce your profit should the stock price decrease to create a ‘cap’, which is the lowest profit you can attain if the price is higher than the strike price.

What is the payoff and profit graph?

What is the break-even point?

The break-even point of a cap can be defined by finding the stock price where the cap generates a zero-dollar profit. By adding the short stock and long call together and equating it to zero, you should solve for ST.

A -G, Options, Options Trading FAQ

Floor

Written by Bavan Arumugam

A floor is an options insurance strategy where you simultaneously have a long open position on a stock and a long put for the same underlying asset. Adding a long put to your open position means that you are obligated to sell your stock at the strike price. The long put ensure that you can sell your stocks at a defined price. Since you already have the stock in your open position, you will gain the difference from the long stock and long put. The combination of those two products creates a payoff that is like a long call. However, the profit is not the same since you spent more on a floor versus a call option.

What are its components?

A floor has two components:

Long Stock
Long Put

When and why should I have a floor?

You should have a floor if you are bullish on a stock and wish to have an extra protection in case the price of the stock goes down. By adding a long put to your long position, you are willing to reduce your profit should the stock price increase to create a ‘floor’, which is the lowest profit you can attain if the price is lower than the strike price. Creating a floor guarantees a minimum stock price for which you can close your current position.

What is the payoff and profit graph?

What is the break-even point?

The break-even point of a floor can be defined by finding the stock price where the floor generates a zero-dollar profit. By adding the long stock and long put together and equating it to zero, you should solve for ST.

A -G, Options, Options Trading FAQ

Covered Put

Written by Bavan Arumugam

A covered put is an options insurance strategy where you simultaneously have a short open position on a stock and sell a put option for the same underlying option. Adding a short put in your open positions means that you are obligated to buy your stocks at the strike price, contingent on the option buyer’s actions. However, you already have the short stock in your open position, which means you will gain the difference from the short stock and the short put. The combination of those two products creates a payoff that is like a short call. However, the profit is not the same since you spent more on a covered put versus a short call.

What are its components?

The covered put has two components:

Short Stock
Short Put

When and why should I have a covered put?

You should have a covered put if you are moderately bearish on a security and wish to have an extra protection in case the price of the stock goes up. By adding a short put to your short position, you are willing to forego the additional profit should the stock drop for protection if the stock increase in price. The effect of adding a short put to your short position can be seen in the profit tables below.

What is the payoff and profit graph?

What is the break-even point?

The break-even point of a covered put can be defined by finding the stock price where the covered put generates a zero-dollar profit. By adding the short stock and the short put together and equating it to zero, you should solve for ST.

A -G, Options, Options Trading FAQ

Covered Call

Written by Bavan Arumugam

A covered call is an options insurance strategy where you simultaneously have an open position on a stock and sell a call option for the same symbol. Adding a short call in your open positions means that you are obligated to sell your stocks at the strike price contingent on the option buyer. However, you already have the stock in your open position, which means you will gain the difference from the long stock and the short call. The combination of those two products creates a payoff that is like a short put. However, the profit is not the same since you spent more on a coverall call versus a short put.

What are its components?

The covered call has two components:

Long Stock
Short Call

When and why should I have a covered call?

You should have a covered call if you are moderately bullish on a security and wish to have an extra protection in case the price of the stock goes down. By adding a short call to your stock, you are willing to forego the additional profit should the stock surge for protection if the stock drops in price. This can be seen in the individual profits of these two components, versus the covered call’s profit.

What is the payoff and profit graph?

What is the break-even point?

The break-even point of a covered call can be defined by finding the stock price where the covered call generates a zero-dollar profit. By adding the long stock and the short call together and equating it to zero, you should solve for ST.

H-M, Options, Options Trading FAQ

Long Call

Written by Bavan Arumugam

A long call is a term used when you own a call option for an underlying asset. A call option is a contract where the buyer has the right (not the obligation) to exercise a buy transaction at a specific strike price at or before an expiration date.

In the world of trading, owing a long call means that you have a contract that gives you the right to buy the underlying asset at a specific price, before a maturity date. Once the contract is exercised, the contract disappears and the underlying asset will be part of your open positions at the specified strike price. If you had a short position on the asset beforehand, exercising this contract will be expressed as if you have covered your short position. The alternative of exercising would be to sell your option contract to another trader on the market.

What are its components? Can you show me how to have a long call in my open positions?

The components of a long call are quite simple. You simply need to perform an order to buy to open an option contract based on your desired specifications:

When and why should I have a long call?

You should have a long call option if you expect the stock price to go up, but would like to have a cushion of protection. As an example, if you own solely the underlying asset and the price goes down, the lost will have a stronger impact on the underlying asset than on the option contract.

What does it look like graphically? What is the payoff and profit graph?

What is the Break Even Point?

N-T, Options, Options Trading FAQ

Short Call

Written by Bavan Arumugam

Recall that a call option is a contract where the buyer has the right (not the obligation) to exercise a buy transaction at a specific strike price at expiration date. A short call is a term used when you sell a call option for an underlying asset.

A trader that has a short call option is also referred as a trader that wrote a call option. This means that the trader wrote this option contract with a belief that the buyer of the contract will not exercise it. If this happens, the writer will pocket the premium from selling the contract. If the buyer of the call option does exercise his right, the writer will have to sell him the shares, with respect to the specifications of the contract. In other words, a call option writer has an obligation to sell shares of the underlying asset, contingent on the buyer’s decision to exercise his rights.

In the world of trading, a short position on a call option (“sell to open”) means that you sold a contract that gives the buyer of that contract the right to buy the underlying asset at a specific price at a maturity date. If the buyer decides to exercise his right, you are obligated to provide him the shares with respect to the requirements that you have both agreed upon. It is important to note that the seller of a call option has no exercising rights. Thus, the only way to close this option contract would be to “buy to close” or cover the contract in question.

What are its components? Can you show me how to short sell a call option?

The components of a short call are quite simple. You simply need to perform an order to sell to open an option contract based on your desired specifications:

When and why should I have a short call?

You should short a call option if you expect the stock price to remain below the strike price. In a situation where the stock’s price is below the strike price, you will be able to gain the premium, since the buyer did not exercise his right. Evidently, writing a naked call (without being the owner of the underlying asset) can be very risky should the price surges beyond the strike price. Traders write options to implement it to certain strategies that will be discussed later.

What does it look like graphically? What is the payoff and profit graph?

What is the break-even point?

H-M, Options, Options Trading FAQ

Long Put

Written by Bavan Arumugam

A long put is a term used when you own a put option for an underlying asset. A put option is a contract where the buyer of the put has the right (not the obligation) to exercise a sell transaction at a specific strike price before an expiration date.

In the world of trading, owning a long put means that you have a contract that gives you the right to sell the underlying asset at a specific price, before a maturity date. Once the contract is exercised, the contract disappears and the underlying asset will be sold at the specified strike price. If you already have the asset in your open positions, it will be sold at the specified price. If you do not own the asset, the sell action will be expressed as if you have shorted the stock. The alternative of exercising would be to sell your contract to another trader on the market.

What are its components? Can you show me how to long a put option?

The components of a long put are quite simple. You simply need to perform an order to buy to open an option contract based on your desired specifications:

When and why should I have a long put?

You should have a long put option if you expect the stock price to go below a specific price, but would also like to have a cushion of protection. As an example, if you short sell the underlying asset and the price goes up, the loss will have a stronger impact on the underlying asset than on the contract.

What does it look like graphically? What is the payoff and profit graph?

What is the break-even point?

Options, Options Trading FAQ

Short Put

Written by Bavan Arumugam

Short Put

Recall that a put option is a contract where the buyer has the right (not the obligation) to exercise a sell transaction at a specific strike price before an expiration date. A short put is a term used when you sell a put option for an underlying asset.

A trader that has a short put option is also referred as a trader that wrote a put option. This means that the trader wrote this option contract with a belief that the buyer of the contract will not exercise it. If this happens, the writer will pocket the profits from selling the contract. If the buyer of the put option does exercise his rights, the writer must buy from him/her the shares, with respect to the specifications of the contract. In other words, an put option writer has an obligation to buy shares of the underlying contingent on the option buyer’s actions.

In the world of trading, a short position on a put option (“sell to open”) means that you sold a contract that gives the buyer of that contract the right to sell the underlying asset at a specific price, before a maturity date. If the buyer decides to exercise his right, you are obligated to purchase from him the shares with respect to the requirements that you have both agreed upon. It is important to note that the seller of a put option has no exercising rights. Thus, the only way to close this option contract would be to “buy to close” or cover the contract in question.

What are its components? Can you show me how to short sell a put option?

The components of a short put are quite simple. You simply need to perform an order to sell to open an option contract based on your desired specifications:

When and why should I have a short put?

You should short a put option if you expect the stock price to remain above the strike price. In a situation where the stock’s price is above the strike price, you will be able to pocket the premium, since the buyer did not exercise his right. Evidently, writing a naked put can be very risky should the price drop below the strike price. Traders write options to implement it to certain strategies that will be discussed later.

What does it look like graphically? What is the payoff and profit graph?

What is the break-even point?

Accounting, Management

Cost Accounting

Written by Kevin Smith

The field of accounting is typically divided into two areas, financial accounting and cost (or managerial) accounting. Whereas the purpose of financial accounting is to report the results and position of a business to external parties, cost accounting focuses on internal reporting for the purpose of improving managerial decision making. This means that cost accounting is forward looking, as opposed to the primarily backward-looking financial accounting.

As a further distinction, cost accounts are not required to adhere to GAAP like their financial counterparts are. This is because they are performing analysis primarily to assist management teams, who do not need the same standardized reporting that is the external requirement. This also means that cost accounting involves some different metrics than financial accounting. For example, physical measures like units produced per hour may be utilized in cost accounting that would never be seen on any financial statements.

To see how this is used in the real world, take a look at two basic cost accounting concepts: cost allocation and cost-volume-profit analysis.

Cost Allocation

Simply put, the purpose of cost allocation is to assign costs to separate jobs or divisions within a company. For example, Ford’s (F cost accountants might want to separate out what costs are going into their car, SUV, and truck segments in order to determine which is the most profitable or which has the potential to become more efficient.

In cost accounting, there are two categories of costs: direct and indirect.

Direct Costs

Direct costs, including direct materials and direct labor, do not require any allocation calculations because they can be applied directly to their job or segment. The cost of metal and components used for an F-150 truck can easily be attributed to the truck segment, as can the worker-hours spent building the truck.

Indirect Costs

However, indirect costs, like the cost to build and maintain factories or manager salaries, are more difficult to allocate. Typically, what a company will do is determine a cost driver for each cost. Cost drivers are activities that cause costs to be incurred—potentially items like machine hours, labor hours, or square footage used. One key task for a cost accountant is to select the cost driver that most accurately predicts actual costs.

Let’s say that we run a bread factory and we have three segments: bread, cookies, and cakes. We have selected machine hours as the cost driver for our indirect costs. In 2017, the factory operates at the following activity level:

Segment	Bread	Cookies	Cakes	Total
Machine Hours	2200	1500	1300	5000

At the end of the year, our company has incurred $180,000 of indirect costs (rent, manager salaries, ect). To determine the amount allocated to the bread segment, we would take 2200 hours (the amount of cost driver used by bread machines) divided by 5000 hours (the total amount of cost driver used by the entire factory) to get 44%. Then, we multiply that value by $180,000 of indirect costs to get $79,200 allocated to the bread department.

2200 bread machine hours/ 5000 total machine hours = 44%

44% *$180,000 indirect costs = $79,200 allocated to bread segment

Through similar calculations, we can allocate 30% of costs to cookies and 26% of costs to cake, reaching allocations of $54,000 and $46,800 respectively.

Analyzing Cost Allocation

In terms of takeaways, this analysis is telling us that the bread segment is responsible for the greatest percentage of our machine hours and accounts for the greatest percentage of costs. Depending on the level of revenue being earned from bread sales, management may look to make bread production more efficient.

Companies usually test multiple cost drivers before making a final decision. For instance, in this example management might look at the square footage of factory space taken up by bread machines vs cake and cookie machines, as space could be a logical predictor of the costs to heat, light, and maintain the factory. This is one of the reasons why Cost Accounting cannot be GAAP compliant – there is an inherent subjectivity that the managerial team needs to make when deciding how they internally allocate their costs, so outside observers will never be able to compare two company’s cost accounts “apples to apples”.

Cost-Volume-Profit

Cost-Volume-Profit (CVP) analysis is a process used to predict future financial performance given various output levels. The basic formula involved in CVP analysis is as follows:

Pre-tax Profit = (Price * Units) – (Variable Cost per Unit * Units) – Fixed Costs

Pre-tax Profit = Revenue – Variable Costs – Fixed Costs

This formula is a simplified version of an income statement. Notice that instead of listing each item (cost of goods sold, depreciation, etc), this formula classifies all costs as either fixed or variable. This is extremely helpful in terms of allowing cost accountants to project the degree to which a company will be more or less profitable given a certain change in output level, but is also somewhat simplistic. In a real-world company, it can be difficult to determine whether certain costs are fixed or variable. However, CVP provides a useful theoretical guideline regardless.

Applying CVP

One common use of CVP is to analyze how much an increase in output will impact profits. Let’s say our factory had the following bread data for 2016:

Bread Segment
Units sold	100,000
Revenue per unit	$4
Variable Cost per unit	$2
Fixed Costs	$150,000

Using our CVP equation, we can easily determine pre-tax profit:

($4 revenue per unit * 100,000 units) – ($2 VC per unit * 100,000 units) – $150,000 FC = $50,000 pre-tax profit

Since in this example revenue per unit is greater than variable cost per unit, increasing units sold will increase profit and vice versa. Another interesting application of CVP is to find the breakeven point, or output level needed to generate a profit of $0.

To find breakeven, we need to set profit equal to zero in the CVP equation and then solve for units (we use the variable x to represent units here):

$0 = 4x – 2x – $150,000

$150,000 = 2x

x = 75,000 units

Therefore, we need to sell 75,000 units to break even on the bread division. Notice that when we solve for x, we simplify and can take out a more direct formula for breakeven:

Breakeven Units = Fixed Costs / (Revenue per unit – VC per unit)

The final term in this equation (Revenue per unit – VC per unit) is often referred to as the unit contribution margin, as it describes the amount per unit sold that a company has available to contribute to covering fixed costs.

CVP, Margins, and Break-Even Applications

In simple cases, the Variable Costs per Unit are fixed, but in the real world they tend to follow a “U” shape as a company increases production. As the company increases production, the variable costs start to go down.

Imagine if you were running your own bakery – If you only bake 2 loaves of bread per week, you will only need to buy one small bag of flour from the local grocery store. Once you get up to 20 loaves, you will probably be buying flour in 25 pound bags – and if you look at the labels at the grocery store, you will see the bigger bags cost less per pound. Once you start producing 200 loaves per week, you might skip the grocery store entirely and work directly with a wholesaler, decreasing your input price even more. This is called “Economies of Scale”.

Diseconomies of Scale

At a certain point, you will also start hitting “Dis-economies of Scale”, where your variable cost per unit starts to increase. One of these is purely the number of man-hours spent baking bread – each employee only works so many hours per week. If all employees are fully utilized, you will need to hire one new employee, lowering the average output per worker. For example, imagine you currently produce 2000 loaves per week, with 5 employees each working as hard as they can. Your employees each earn $20/hour, and work 35 hours per week. To calculate the current variable cost per unit due to labor, you would calculate:

Total Salary Cost = Total Employees * Hours per Week * Hourly Wage

Total Salary Cost = 5 * 35 * $20 = $3500

Current Labor VC per Loaf = Total Labor Cost / Total Loaves Produced

Current Labor VC per Loaf = $3500 / 2000 = $1.75

Now if your company wants to bake 2100 loaves next week, you will need to hire a new employee. This new employee is currently under-utilized, which means it impacts your average cost per loaf.

Total Salary Cost = Total Employees * Hours per Week * Hourly Wage

Total Salary Cost = 6 * 35 * $20 = $4200

Labor VC per Loaf = Total Labor Cost / Total Loaves Produced

Labor VC per Loaf = $4200 / 2100 = $2.00

The other biggest concern that can cause diseconomies of scale include maximizing the machine hours per worker – if you have too many bakers in the bakery, some may be idle waiting for an oven to free up.

Double Break-Even

This means companies have two break-even points: the first is the minimum they need to produce and sell to pay their expenses, and the next is the maximum they can sell before diseconomies of scale eat all of their profits.

Managers use both points every day. The lower break-even point brings up a “shut-down” question – is it more profitable in the long run to continue producing that good at all, or are the current resources it uses able to be better utilized elsewhere. The higher break-even point raises a flag for reinvestment and efficiency evaluation – as variable costs increase, managers decide if more capital (in our example, more or bigger ovens in the bakery so each baker gets plenty of machine time), or different production processes can be implemented to keep profits flowing as business grows.

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Accounting, Finance

Creating Financial Statements

Written by Jinni Raisa Alingasa

A company’s financial statements give investors, managers, and other “users” a complete, honest look at its financial health. Finished financial statements follow a standardized format, letting investors compare different companies in the same industry apples-to-apples.

For the company’s financial reporting team, this presents a challenge – every business’s internal operations are different, but all activities need to be summarized into a standardized format. Businesses assign teams to create their financial statements to meet this challenge – the Income Statement, Balance Sheet, Cash Flow Statement, and other smaller reports issued by every publicly-traded company.

Financial statements follow a logical sequence – each statement needs to be completed and used as an input to the next.

Worksheets

Financial statements are summaries of activities, so the first step in creating any financial statement is to start by building worksheets. Worksheets are updated almost daily with raw data – all sales, expenses, depreciation, and any other flow of money into, out of, or within a company.

Worksheets are the first step in translating the unique way each business operates into easily-understandable, standardized financial statements. This means each company’s worksheets for each type of financial statement is unique – their accounting and financial analysis teams work together to build worksheets that help distill business operations into raw financial data.

Building Worksheets

Worksheets start with the general ledgers of a business, and sort the data into the categories they need to build the standardized financial statements. This is usually a set of spreadsheets – a separate set of worksheets used to build each type of financial statement.

Building worksheets is time-consuming. Some smaller businesses with an owner-operator trying to build their own financial statements may try to skip building worksheets, and instead convert their raw ledger data directly into finished financial statements. This can save some time if they only want to produce financial statements very rarely (like when applying for new bank loans), but lends itself to errors and headaches for companies with normal reporting schedules.

Building new worksheets takes care – any change to worksheets needs to be verified that it will be consistent with previous financial statements, and conforms to GAAP.

Income Statement

Income statements try to answer one simple question: how much money did this business make or lose? This means income statements look at all transactions over a given period of time, usually a quarter or year. The final product of the financial statement is to be able to produce the following equation:

Net income = Revenues – Expenses

It is in this document that revenues are matched with expenses to determine whether a company has net income (revenues are more than expenses) or a net loss (expenses are more than revenues). The worksheet can be a helpful tool in starting and completing an income statement. The format of an income statement can change depending on the type of business.

The basic format is to have the revenues mentioned first and the expenses afterward. The revenue accounts are sales, fees earned, rent revenue, dividends revenue, and any other revenue that all depends on the type of business. The operating expenses are either selling or administrative, but expense can vary depending on the type of business. However, in general, expenses come from advertising, delivery, depreciation of the building, depreciation of equipment, salaries, and wages, and many other things that a business needs to incur to keep the company up and to run.

Revenues

Each company is different, but to simplify let’s say that Apple splits their revenue up into Sales revenue, Interest revenue, and gains on sales of assets. Their revenue would look something like this.

Revenues
- Sales Revenue – $1,500,000
- Interest Revenue – $250,000
- Gains on Sales of Assets – $100,000
- Total Revenue – $1,850,000

Expenses

Expenses work in a similar format but are obviously categorized as money going out of the company. Apple, if simplified again would have their expenses split into Cost of goods sold, interest expense, commission’s expense, and loss from a lawsuit. Their expenses would look something like this.

Expenses
- Cost of goods sold – $950,000
- Interest expense – $50,000
- Commissions expense – $75,000
- Loss from lawsuit – $250,000
- Total expenses – $1,325,000

Once this is all tied together at the end the final number is the net income and is calculated by subtracting total expenses from total revenue. This would look like this.

Net Income = $1,850,000 – $1,325,000 = $525,000

Retained Earnings

Retained earnings are a portion of accumulated net income that gets repurposed into other assets and liabilities for the benefit of the firm. At the discretion of the company, retained earnings can also be distributed to stockholder’s as dividends.

Retained earnings are calculated by taking the beginning balance of retained earnings and adding any net income (subtracting net loss) and deducting dividends to get the ending balance of retained earnings for the year-end.

Ending Balance of Retained Earnings = Beginning Balance + Net income (- Net loss) – Dividends

The retained earnings statement is not a mandatory financial statement to have. A company can furnish it to give internal users a better idea if securities should be issued, repurchased, send out dividends, fund new projects, or take in more debt. Its purpose is to help a firm make better investment choices than the previous period.

Shareholder’s Equity

The statement of shareholder’s equity is a stripped-down version of the Retained Earnings statement, with more emphasis on the actual stock of the company. This one is mandatory, and will later be used when building the Balance Sheet.

The statement of stockholder’s equity reports on changes in the stockholder equity accounts such as preferred stock, common stock, additional paid-in capital, retained earnings, and treasury stock. Other accounts such as accumulated other comprehensive income (loss) and noncontrolling interest are included in the statement of stockholder’s equity.

This statement is important because it reveals the contributions and distributions of a company about the accounts just mentioned and the adjustments processed in the period that they cover. In other words, it gives investors a clear picture about what is happening with their stock (diluted with more shares, if the company is buying back shares as treasury stock, ect).

Balance Sheet

The Balance Sheet is the biggest of the main financial statements, and the last to be prepared. The balance sheet will “balance” all of the assets, liabilities, and shareholder’s equity at a specific period of time. While the Income Statement will look at the flow of money over a period (month, quarter, or year), the Balance Sheet is a snapshot – showing its balance at a precise moment in time.

The goal of the Balance Sheet is to give users a picture at a company’s solvency and flexibility. How well are they able to make payments on debt? How liquid are their assets, and how financially flexible are they to whether any unexpected market shocks? This is done by first breaking down, then summing up, the different categories of assets and liabilities, and showing how this compares with shareholder’s equity and retained earnings.

The asset accounts include current assets (cash, accounts receivable, supplies, prepaid expenses, etc.), long-term investments (equity investments), property-plant-and-equipment (land, building, etc.), and intangible assets (goodwill, trademarks, etc.). The liabilities accounts include current liabilities (liabilities within one year or less – notes payable, accounts payable, income taxes payable, salaries payable, etc.) and long-term debt (debt that is more than one year). The stockholder’s equity accounts can come from contributed capital from the issuance of stock, additional paid-in capital, retained earnings, accumulated other comprehensive income, treasury stock, and various equity accounts, which depends on the type of business.

Comparing balance sheets over time will usually give a very clear picture of a company’s financial health.

Cash Flow Statement

The Cash Flow statement can be produced at any point between any of the other statements. Cash does not necessarily mean income, so the purpose of the Cash Flow statement is not to show profits or loss – the Cash Flow Statement bridges the gap of information from the Income Statement and the Balance Sheet.

Like the Income Statement, the Cash Flow Statement shows the flow of money into, out of, and within a business over a period of time. Unlike the income statement, it is not concerned with “net income” or “net loss” – rather, it tries to help paint a picture of liquidity, like the Balance Sheet. The Cash Flow statement needs to answer exactly how the “Cash” line of the balance sheet is calculated.

It is here that the total amount of cash reported on the balance sheet (the ending balance) is explained based on the cash out-flows that are deducted from the cash in-flows. To prepare the statement of cash flows a company looks at prior periods balance sheets to make a comparative analysis (to see what increased or decreased), the current periods income statement to help calculate the net cash provided from operating activities, and any data from transactions that have occurred.

Cash Flow Calculation Steps

Cash flows from operating activities – This should be the bulk of cash flow in most businesses, calculating the cash flow from normal business activities, including amortization and depreciation.

Add Net income + Depreciation expense + Amortization + Loss on sale of plant assets ( – Gain on sale of plant assets) + Decrease in accounts receivables ( – Increase in accounts receivables) + Decrease in inventory ( – Increase in inventory) + Increase in accounts payable ( – Decrease in accounts payable) = Net cash provided (used) by operating activities

Cash flows from investing activities – If a company has investments outside its normal operations, this cash also needs to be accounted for. This often comes from selling assets for most businesses.

Add Sale of plant assets (Subtract purchase of plant assets) + Sale of equipment ( – Purchase of equipment) + Sale of land ( – Purchase of land) = Net cash provided (used) by investing activities

Cash flows from financing activities – This relates to Shareholder’s Equity – how is invested money being used, and the movement of cash into and out of stock.

Add issuance of stocks – Dividend payments – Redemptions and repurchases = Net cash provided (used) by financing activities

Once the amounts of each category are determined, they are combined by taking the sum or difference of the total amounts to get the net increase in cash (more cash coming in than coming out) or net decrease in cash (more cash being spent than being earned).

Net increase (decrease) in cash + Cash at the beginning of the year = Cash at the end of the year (the total cash you see on the balance sheet)

Consolidated Financial Statements and Annual Reports

Every company reports their financials every year on a different date depending on their fiscal year. Some do it in the winter, while others choose the summer. This report is an all-inclusive finding on what the company has been doing for the previous year – wrapping all of these financial statements into one big bundle for publication called the 10k.

The report starts with a description of the company and what they do. From there they describe any new changes during the year such as mergers or acquisitions. After a few pages of qualitative descriptions of their year, the reader runs into their financial statements. This is a great way to read over their income statement, balance sheet, statement of stockholders equity etc. and really understand how they have been doing over the past year and if they’re improving or declining.

Below is an example of the table of contents from Nordstrom’s (JWN) 2018 annual report and as you can see it is a lot of information. In short, the nature of a company’s annual report is to provide an enormous amount of information the general public and their stockholders to help them understand how the company is doing. It takes a lot to read through these reports and pull the information needed, but they are created by the companies for a reason and are a great way to learn more about them! You can find the 10k of any company with public stock by looking them up on the Quotes page, then clicking “SEC Filings” on the left.

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Economics

Risk

Written by Kevin Smith

Risk is one of the most important concepts in investing, economics, and personal finance. Our appetite for, or aversion to, risk is the biggest driver behind spend and save decisions. Despite this, very few people really understand just how big a role risk plays in our everyday lives.

Risk Definition

“Risk” is the probability for an event to not go the way we hope. Every event in the future, and every event we plan for has at least two outcomes: the way (or ways) we hope it goes, and the way (or ways) it could go wrong. There are two types of risks – the kind where we know the likelihood of failure, and the kind where we do not.

Well-Defined Risk

A dice roll is a well-defined risk – each side has an exactly 1/6 chance of rolling up

If a risk is “well-defined”, then we can usually find an exact probability of things turning out well, or things failing. Investing in a bond is one example of this – there are tons of investment research firms that publish risk assessments of a bond being paid back in full and on time.

This is usually expressed as a percentage or ratio of success vs failure. For example, a US Treasury Bond has a 99% chance of paying itself back on time, and less than 1% risk of default.

Poorly Defined Risk

A risk is “poorly-defined” if we do not have access to all this research – when we are making wild guesses at the chance of failure. Most researchers start by assuming any event has a 50% chance of failure, then update that estimate as more information is added.

Nearly all risk starts as “poorly defined”, but research into other past events helps us clear the mystery. For example, if you have never heard of a company trading on the stock market, you would have no idea if it would make a good investment or not (a 50% chance of success, and a 50% chance of failure).

You could start your research by looking at the company’s history – if they have been in business for a long time with steady profits, it would reduce the risk of failure. If it looks like they just started listing their stock yesterday with no real profits yet, it would increase the risk of failure.

Risk and Interest Rates

If someone needs to borrow money, their lender would consider the “risk” of that loan being paid back when determining the interest rate.

For example, a bank may have a 3% baseline interest rate – they want to earn a 3% rate of return on any loans they issue. Every time a borrower asks them for a loan, they will do research into this person’s income and credit history to get a picture of how much risk there is for the loan.

Calculating Interest Rate with Risk – Expected Value

Imagine a borrower wants to borrow $1,000 from the bank for a 1-year loan. The bank starts with their baseline interest rate of 3% – they want to make sure that they can expect $1030.00 at the end of the year.

After doing their research, they estimate that the borrower has a 10% risk of failing to make the payments (a Well-Defined risk). If he fails to make all the payments, they do not know how much they will get back (a Poorly-Defined risk). Since this is a poorly defined risk, they will assume they will get half their money back if he fails at some point.

To calculate the interest rate they plan on charging, they want to make sure the expected value of the loan is $1,030.00 – the same as it would be if there was no risk. To calculate the expected values, they will assign the probabilities to each outcome – 90% he pays in full, 10% that he fails. They will then pick an interest rate that will make the expected value equal to the $1030.00 that they want to finish with the loan.

((Probability of paying back the loan X Full Payment) + (Probability of not paying back the loan X Partial Payment)) X (Interest Rate + 1) = $1030.00

((90% X $1030.00) + (10% x $515.00)) X (Interest Rate + 1) = $1030.00

($927.00 + $51.50) X (Interest Rate + 1) = $1030.00

$978.50 X (Interest Rate + 1) = $1030.00

Interest Rate + 1 = 1.0526

Interest Rate = 5.26%

At the 5.26% interest rate, the bank will get $1052.60 if the borrow pays back the full loan. The extra amount that they get beyond their original 3% is what they charge to cover the risk of the loan.

Risk and Psychology

A person’s appetite for risk will greatly change how they behave when faced with uncertainty. People try to minimize the amount of risk they need to manage, and will prefer a “sure thing” to balancing an expected value.

Risk Aversion

This leads to the idea of “Risk Aversion”. For example, imagine a coin toss game: heads, you get $100, tails you get $0, or you can just take $50 without flipping the coin at all. Most people would take the $50, because the cash-in-hand is better than the risk of 0. If you think you would still go for the coin flip and hope for the $100, we can just move around the starting positions: you can bet $50 of your own money to play. The expected value of all 3 choices is the same (you end with 0 for a tails, $100 for a heads, or $50 by walking away), but most people “feel” like it is a completely different game.

There is a practical application to this too – less risk makes it easier to plan. In the example of the bank trying to determine the interest rate, most banks will actually “round up” the interest to 5.5%, just to compensate the fact that they are taking a risk at all. As the size of the loan grows, so would be the “pain” in the even of a loss – this means bigger loans will often have higher interest rates, even with the same level of risk.

Risk Appetite

Different people have different levels of risk aversion, and this will change as we change what is at stake. In our coin toss example, we can lower the stakes: heads you get $1, or you can take 50 cents without a toss. In this case, a lot more people would take the bet on the coin toss, since the risk involved is quite small.

Compare this to much higher stakes – what if $1 million was on the line for a coin flip, or $500,000 for free? Very few people would take the flip – even though $1 million is twice the reward, losing the $500,000 represents a much bigger risk.

A person’s appetite for risk will also determine what kinds of investments they will make. A person who has a much higher risk tolerance will shoot for volatile stocks that have a lot of price movement – trying to maximize their return. Someone with a lower risk tolerance is more likely to invest in big blue-chip stocks and bonds – not much of a return for price, but looking for a steady stream of dividends and interest payments.

Problems in Risk Assessment

This does present a problem for some investors – people are generally bad at assessing risk. It can be hard and time-consuming to fully research the pros and cons of one investment over another.

When looking at the spending patterns of large groups of people, we see that people tend to over-estimate the probability of unlikely events, mostly because the rare occurrences get a lot of attention. A perfect example of this is the lottery – the expected value of a lottery ticket (the % chance of winning times the amount you would win) is much lower than the price of the ticket, so a savvy investor would never buy a ticket. However, lottery winners get a lot of media attention, so there is a constant reminder that “YOU COULD BE NEXT!”. This brings emotion into the equation – encouraging participation and disregarding some of the risk.

Reducing Risk

A key skill in personal finance and economics is understanding how to reduce risk, and “lock in” more real returns. The two ways people and businesses reduce their risk is through diversification and insurance.

Diversification

Diversification means spreading out investments and assets. An investor would do this buy picking stocks in different industries, like a mix between agricultural, healthcare, and technology stocks. A business does this by opening separate brands or product lines – Coca-Cola (KO) also produces Dasani water, Minute-Maid fruit juices, and Vitamin Water to diversify its product line.

Diversification works because while different stocks might have the same level of risk, the triggers that would cause a loss are not likely to happen at the same time. If there is a drought, for example, agriculture stocks might lose money, but this would represent a smaller fraction of a portfolio, limiting the loss.

Insurance

Risk can be addressed directly by buying insurance. Insurance works the same as the banker deciding the interest rate for a loan.

Every time you buy an insurance policy, the insurance company starts by assessing how much loss you might face, and what the probability would be of that loss happening. The premiums charged by insurance companies have 2 parts:

The percentage of profit they want to make on all policies (for the bank, this would be the 3% profit they aim for on all loans)
Enough of a premium so the expected loss from filing a claim is 0.

For example, imagine you want to buy a $100,000 life insurance policy. Your insurance company targets a 5% profit on all policies, and they estimate that each year, you have a 2% chance of dying unexpectedly. They would set your premiums to make the expected value of paying out the policy zero, plus a 5% return on investment.

Annual premium = (Probability of having to pay out X Amount to pay out) X (Return on investment + 1)

Annual premium = (2% X $100,000) X (5% + 1)

Annual Premium = $2,000 X 1.05

Annual Premium = $2,100

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Economics

Property Rights

Written by Kevin Smith

Property rights is the foundation of all free-enterprise economic systems. It is what allows people to profit from capital and ideas, without fear of seizure by the government or theft.

Definition

“Property Rights” usually refers to a set of fundamental rights giving citizens control over their own land, capital, and ideas.

Land Property Rights

The property right to Land gives a landowner exclusive use of their property – other citizens and the government cannot use someone else’s private property (although the government does have the right to purchase any private land).

The right to Land is protected by the 5^th amendment to the Constitution, which (among other things) requires the government to compensate landowners if their land is seized for public use, and the 3^rd amendment, which prevents the government from requiring citizens to house soldiers on their own property.

Capital Property Rights

Capital property rights give people the right to own “stuff”. This includes economic capital goods, like tractors, factory machines, and tools, but also the accumulation of wealth. Capital property rights are important because it allows people and companies to build up the means for production without worrying about it being taken away.

The right to Capital is protected by the 4^th Amendment to the Constitution, which protects against unreasonable searches and seizures, but is limited by Article 1 of the Construction, which does give Congress the right to levy taxes.

Intellectual Property Rights

Intellectual property rights give people and businesses exclusive rights to profit from their ideas though the use of patents and copyrights. This means if you write or invent something, another manufacturer cannot simply copy your idea and profit from it themselves.

Intellectual property rights are protected by Article 1 of the Constitution, which charges Congress with establishing the Patent Office.

Weak Property Rights

The United States has strong property rights. To understand what this means, examine some systems with weaker rights.

Weak Land Rights: Rents System

A country with weak property rights would typically bar most citizens from owning land. A clear example of this would be most of Europe during the Middle Ages: all land was owned by the royalty or nobility. Commoners would need to rent smaller parcels from the nobility for their own use, and could be evicted at any time.

This meant that if you were a commoner, you would have no incentive to make improvements on your land. If you were to work hard to build an extension to your house or improve your farmland, it could just be lost the next year based on the whim of nobility. This discourages investment and improvements to land, hurting long-term growth.

Weak Capital Rights: Excessive Taxation

If a country has weak capital rights, it means that businesses and savings can be easily “appropriated” by the government, usually through very high taxes, but occasionally through direct seizure.

With excessive taxes, the government levies extremely high income taxes on individuals and businesses. This effectively makes it harder to generate a profit from any innovation, and can discourage investment. There is no clear-cut point where taxes become “too high”.

An example of excessive taxation would be the “Plunder Economy” of Sweden in the mid 1300’s. The Plunder Economy started when a new King conquered Sweden, and immediately raised taxes on the commoners by over 700%. This caused a large “ripple-up” effect: forced between eating, paying taxes to the crown, and paying rents to their landlord, many commoners defaulted on their rent payments. The breakdown of rents meant landowners also failed to meet their tax obligations, causing the seizure of thousands of farms from small landowners to the ruling aristocracy (causing a further violation of Land Property Rights).

Weak Intellectual Property Rights – Piracy

Weak property rights means that there are little or no protections of unique ideas from being copied. This makes it much harder for individuals and companies to justify large expenses in tech-heavy or creativity-heavy industries.

A major example of weak Intellectual Property Rights would be the film industry of Nigeria. Nigeria is the second-biggest film producer in the world in terms of the number of movies produced – behind India, but ahead of the United States. However, most Americans may have never heard of it at all – and many of the industry leaders in Nigeria are concerned it is on the brink of collapse. This is due to rampant piracy. New films produced in Nigeria are often stolen by lower-level (and even higher-level) employees involved in the film’s production, and immediately sold in massive quantities on the black market (often before the movie is even released).

This means most films have an extremely hard time recouping their investment – with some filmmakers threatening to leave the country entirely. This led to a generation of extremely low-budget films (usually shot on home video equipment), since film makers usually only had a few days of theater sales to recoup their entire investment before legitimate copies are drowned by pirated sales.

Property Rights and Growth

Strong land and capital property rights mean investors and innovators are more likely to see a return on any profitable investment – strong property rights are usually seen as required for economic growth. The reasoning is simple – investors and innovators are more likely to pursue new ventures if they know that they will benefit if it is successful. If a potential investor believes their profits will be syphoned off even if their investment makes money, they will be more inclined to put their savings elsewhere (or simply spend it on consumption).

Intellectual Property Rights, Growth, and Development

Experts are less certain on intellectual property right’s impact on growth and development.

Growth

“Growth” means pushing out the total economic frontier – the most advanced technology that powers the growth in fully-developed economies.

On the one hand, innovators are more likely to pursue their ideas if they know they will enjoy the exclusive right to benefit from their idea through a patent or copyright. Big companies like Intel and Microsoft file patent and copyright protections to their inventions and development, and use their exclusive rights to generate more profits from something that otherwise could be easily reproduced. These profits are fed back to feed more innovation within the company, which continues to push the cutting-edge of technology.

On the other hand, all innovation is based on the works that come before it. By restricting the use of innovative ideas, it prevents another innovator from pushing an idea up to the next level. This became a problem with the Wright Brother’s airplane – the brothers immediately patented their invention, and spent the next decade trying to sue other American aircraft designers who were developing other designs. This infighting caused American aircraft designs to lag French and German designs (who were busier competing for the best design rather than first design) for the next 10 years.

Development

“Development” is different from growth. A “Developing” economy is playing catch-up with developed economics, trying to evolve its stock of technology and expertise. Strong international intellectual property rights are usually more of a nuisance than benefit for developing countries because it makes it more difficult to catch up.

For example, if Monsanto (MON) develops a new type of corn that produces twice the output for the same size of farm, they will likely charge a much higher price for the seeds than generic corn. Richer farmers in developed economies can use some savings to invest in the more expensive seeds, which will greatly increase output. Meanwhile, poorer farmers in developing economies might struggle to afford the newer seeds, and can be stuck using the less-productive forms.

Since the farmers of the richer economies are now producing much more corn, it will also drive down the global price. This hurts the developing farmers even more, since they earn even less income than they were before. Companies like Monsanto know this, and usually have very different pricing strategies in different countries (after all, it is better for their business if the most farmers possible use their products).

Evolution of Intellectual Property

Economies experiencing very rapid development usually maintain “laxer” intellectual property protections to help drive their own growth. This is why the fastest-growing economies are often synonymous with cheap knock-offs: think the Nigerian film industry, or many aspects of the Chinese manufacturing industry.

However, as the level of technology in an economy catches up with the cutting-edge of the rest of the world, the government tends to start enforcing stronger intellectual property protections to help its own industries push forward in the global marketplace. For example, in the 1960’s, Japan had a reputation for producing cheap, flimsy knock-off products. Over the 1980’s and 1990’s, their development reached a point where their economy transitioned from knock-offs to some of the highest-quality merchandise, especially for tech-heavy goods. Today they are considered a global leader with strict intellectual property laws, since the their growth and development focus has shifted towards protecting their own innovation than catching up to innovators elsewhere in the world.

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Economics

Monetary Policy

Written by Kevin Smith

The government has two main ways it tries to influence the economy – through Fiscal Policy and Monetary Policy. Fiscal policy is the more direct approach, where the government levies taxes and subsidies to try to balance its budget while encouraging growth, while monetary policy is less direct – tweaking interest rates and modifying the money supply.

What is the Money Supply?

The money supply is the total amount of money in circulation at any given time. This number will be quite different depending on what type of money you look at. Economists generally group the “money supply” into four categories based on liquidity. The more liquid the type of money (meaning how easily it can be spent), the more restrictive its money supply category.

M0 – Cash

The most restrictive picture of the money supply is the physical cash and coins. In other words, how much currency is circulating in the economy. M0 does not count any “electronic money” (like money deposited into a checking account). M0 is not used very often anymore, since it is so easy to spend money directly from a bank account.

M1 – Cash + Checking Accounts

The next level up is M1 – or “liquid money”. This is all money which can easily be spent immediately, so it includes both cash and checking accounts. M1 is much bigger than M0, since most people usually hold a lot more money in their checking accounts than they do as cash.

M2: Cash + Checking + Saving

M2 is even bigger – it includes everything in M1, plus anything deposited into savings accounts and some Certificates of Deposit. This is in a separate category because there is another level needed before this money can be spent. Usually you would need to transfer money from your savings account into your checking account before you can spend it, making it slightly less liquid. M2 is sometimes called “Near-Money” because of the need to make a transfer before you can spend it. This is the most commonly-used measure of the money supply as an indicator of economic growth.

M2 is very commonly used as a stand-in for “Money Supply”. Because it includes most types of deposits, it includes the “Money Multipliers” from fractional reserve banking (see our article on How Money is Created for details).

M3: Cash + Checking + Saving + Money Markets

M3 is even bigger than M2 – it also includes high-interest savings accounts that put restrictions on withdrawals. These are called “Money Market” accounts (or some bigger Certificates of Deposit also qualify). With these accounts, the depositor gets a higher interest rate than a typical savings account, but they need to maintain a very high minimum balance, and are limited on how many times they can withdraw.

Because of these restrictions, money market accounts are “less liquid” than normal savings accounts.

Monetary Policy – The Big Picture

Monetary policy is set by the Federal Reserve Bank, not by Congress and the President. This is important, because it means that monetary policy is usually more removed from the normal “politics” of Washington. The Federal Reserve has two main objectives for monetary policy: encouraging economic growth, while controlling inflation.

Inflation and Growth

Inflation and growth are closely related. The economy grows when more people invest their savings to help business grow, and spend more money on consumption. This means growth is usually funded by borrowing – most businesses take out loans to help fuel their own growth.

Taking out loans causes the money supply to grow, while paying it back will cause the money supply to shrink. This means over the entire life of the loan (from initially borrowing it to fully paying it back), the money supply does not change. However, businesses will spend the loan before paying it back, putting that money into circulation.

If the economy is growing, it means more people are taking out loans today than they were yesterday. This means that the money supply grows before the rest of the economy – which causes some inflation.

Inflation caused by growth – example

Step 1: Business takes out a loan (increasing the money supply)
Step 2: Business uses the loan to hire a new employee, and pays the new employee their first paycheck (putting the money into circulation)
Step 3: The business provides a service to one of its clients, and gets paid for it (generating a profit)
Step 4: The business pays back its loan

In this example, the business pays its employee, and the employee spends their paycheck before the business gets paid by its client, and pays back its loan. This means that while businesses take out loans to drive growth, that money enters the economy before new value is added (meaning the growth the business causes). In the time between when the employee is paid and the business provides its service to the client, money was added to the economy, but no growth was added. More money but no growth means a small amount of inflation.

This same cycle is repeated millions of times every week, with people and businesses taking out and paying back loans. Since there will always be a time delay, the money supply needs to grow before the rest of the economy: the source of “Inflation by Growth”.

Runaway Inflation

Runaway inflation is what happens when this balance breaks. If too much money enters the money supply before it starts to get paid back, businesses start counting greater and greater “expected” inflation in their business plans. This means businesses start raising their prices more and more just to make sure they can afford their expected higher costs, forcing all other businesses to do the same.

This means prices continue to rise without any extra value added to the economy. In real terms, the effect is that individual’s savings loses its value, and paychecks are worth less.

The Federal Reserve uses monetary policy to maintain the balance between inflation and growth: encouraging businesses to borrow and grow, but deterring runaway inflation.

Tools of Monetary Policy

The Federal Reserve has three tools at its disposal when determining money supply: Interest Rates, Reserve Requirements, and Bond Buying.

Manipulating Interest Rates

This is the biggest tool in the box. The Federal Reserve directly sets what is called the “Federal Funds Rate”, which is the interest rates at which banks lend money to each other. This is the baseline “risk free” interest rate for banks, so if the Federal Funds rate goes up, all other interest rates go up, discouraging borrowing. If the Federal Funds rate goes down, all other interest rates go down, which encourages borrowing.

Every month, the Federal Reserve monitors all economic data across the United States, and meets to discuss inflation and growth levels. If it looks like inflation is pushing too high, they will increase the Federal Funds rate. This will decrease the total number of new loans that people and businesses take out, pushing down the inflation rate.

If it looks like the economy is struggling to grow, they do the opposite – lowering the federal funds rate to encourage borrowing and growth. The Federal Reserve changes the interest rates frequently to match the economy – there will be an announcement of the next month’s policy (go up, go down, or stay the same) every month.

Reserve Requirements

There are limits to how much can be done just by tweaking interest rates. For example, if there is high inflation but low economic growth, both raising and lowering the interest rates look like bad options.

Another tool they can turn to is changing the reserve requirements for banks. At the end of each day, banks need to keep a certain percentage of deposits “in the vault”, or not loaned out. This is called the “Reserve Requirement”, and it puts a hard limit on how much money banks can loan out at any given time.

If inflation is high but growth is low, the Federal Reserve can lower the reserve requirement. This will let banks make more loans to fuel growth, but still keep the interest rates high to try to fight inflation. This is a one-way tool – if the Federal Reserve lowers the Reserve Requirement, when the economy does start growing again they will need to raise it back up (or risk not being able to use this tool in the next crisis). Reserve Requirements do not change very often – usually less than once per decade.

Bond Buying

Bond Buying, or Quantitative Easing, is the most extreme form of monetary policy. This is a new tool that was developed in response to the 2007 economic crisis, when inflation and growth were both low, but interest rates could not be lowered.

When investors and businesses think that the economy is shrinking, they tend to pull their money out of markets and into “risk-free” assets like bonds, where they have a guaranteed return. Buying bonds in large numbers decreases the money supply, since it pulls the money out of banks and circulation. Less money available means less loans, and less growth overall – the money supply needs to be growing for the economy to grow.

For this tool, the Federal Reserve buys huge quantities of bonds from the Treasury, then immediately sells then on the open market. This floods the Bonds market, lowering the prices (and returns) for bonds. Business and investors then see bonds as a “less profitable” investment, pulling their money back into other businesses and investments, increasing the money supply, and opening the door to growth.

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