This Week In Finance

"Dow Takes Biggest Point Loss Since '87 Crash"

Money Daily's online news service (contact them at moneyadm@PATHFINDER.COM) used the above headline in reporting on the gyrations of the stock market during the week of June 23, 1997. As you know, the DJIA fell 192 points one day, then rebounded the next day, rising 152 points. Coincidentally, the day of the large drop, I was lecturing on security valuation from Chapter 6 of RWJ's Fundamentals of Corporate Finance, 3e. As I listened to the news that evening, I began to wonder how I could integrate it into my next lecture.

Below is a brief description of how I did so. I hope you will find it useful in integrating news items into your courses. One of the most difficult (and important) tasks in teaching is to induce students to think about how various topics hang together, so they can think completely through a problem or situation. The actions of the market provide a means of doing so.

Early in the Intro Corpfin course, I define a "rational investor" as one who likes returns and dislikes risk. Following a few examples, I suggest that a key implication of this assumption is the fact that a graph of the trade-off between expected returns and risk is upward-sloping. (Note: this is an easy way to sneak the SML into the lectures early on; when it is formally discussed in later chapters, the students see it as perfectly natural.)

Now, the market's fall and rise was attributed in various news stories to comments made by the Japanese Prime Minister that his nation may be unwilling to acquire U.S. Treasury securities to the extent that it has for several years. Use some strategic questioning (and prodding) to allow students arrive at the following line of reasoning.

(1) The Prime Minister's comments affect investor expectations about required returns on government bonds;

(2) Required returns rise and bond prices fall (as happened the day of the initial comments);

(3) The rise in the risk-free rate results in a parallel upward shift in the SML. (Since the class has been previously introduced to the concept of a graphical risk-return trade-off, if not to the term "SML", this is easy to put on the board);

(4) As a result of the rise in the SML, the required returns on risky assets rise too; using the constant-growth model, it is straightforward to show that share prices should, cet. par., fall too.

(5) Finally, the Prime Minister's subsequent "clarification" of his comments influences investor expectations in the opposite direction, the chain of events moves in reverse, and share prices rebound.

While going through this exercise with the class the next day, I noticed several students nodding in agreement (as opposed to nodding off), and later received comments that it was "nice to see the models and equations used to explain real-world events." A left-handed compliment? Perhaps. An oversimplification of the facts? Undoubtedly. But the value of the exercise was undeniable - as a group, the students worked through and integrated materials from Chapters 1-6, and found them useful in explaining the world around them. As a long-time instructor of the introductory course, I can't help but feel a small sense of accomplishment.