Everything I Know Knew About Finance I Learned From Prosper
I’ve really only been a finance major for just over a semester, yet I feel like I feel like I have been for much longer. At the very least, I now understand what recruiters are talking about at networking events, and I can usually figure out what most of the common acronyms stand for. Before I enrolled at NYU Stern last semester, I was able to say that everything I know about finance I learned from Prosper. Now, I may have to amend that statement and say that everything I knew about finance, prior to coming to NYU Stern as a finance major, I learned from Prosper. I came to Stern to learn finance, but in reality, I learned that I really should be here to learn (and still have a lot to learn about) how to fit into the financial world.
Prosper is an online peer to peer based lending/borrowing service. That is, some users lend to other users who borrow. Borrowers sign promissory notes upon receiving money which lenders can then hold onto and collect month to month or trade in the Prosper market. This sounds like trading any kind of financial security, doesn’t it?
Rules of finance I’ve learned from Prosper:
Prices of securities and interest rates are determined by the market to satisfy the laws of supply and demand
When borrowers on Prosper apply for a loan, they often start with an interest rate higher than they are expected to pay. In practice, it actually does not matter what rate they start at, as the market will adjust to a rate that seems fair considering risk and return. In this example, this borrower has a AA rating, the highest possible in Prosper. The initial offered rate was 12.50%, but at this rate, more lenders would be willing to supply money than the $15,000 demanded. Thus, during the bidding process before the loan is written, lenders compete by gradually bidding lower rates that they are willing to accept to loan to this borrower. My prediction is that within the time remaining, the loan will probably be bid down to about 7%, typical of low risk AA.
Investors demand higher expected rates of return for higher risk/volatility
So, if two investments have the same expected return but different level of risk, then it is only natural that the rate for the lower risk investment will be bid down (explained in the previous rule). Prosper offers portfolio plans, and they clearly show that more aggressive investing equates to higher expected yield.
Diversification is the way to go
Prosper’s system even suggests that you should invest with a small amount per bid and in many different loans. This is a simple concept: If you invest everything in one loan and that person defaults, then you lose significantly. However, if you invest $25 in each borrower and lend to many different borrowers, then your return will be comparable to the expected return. Some loans will default, but Prosper even calculates the expected losses based on credit rating for you.
The value of your existing security varies based on market interest rates
This is the concept of interest rate risk. Basically, the first time you decide to sell a note, you will discover that the amount you can sell it for ma not necessarily be what you paid for it with adjustments for already received payments. This is because new notes are constantly being issued, so the selling price of existing notes is adjusted for difference in yield. For example, if you bought a $25 note when the market rate was 5% but the market rate is now 7%, nobody is going to give you $25 for your note when they could buy a new one and receive 7% (provided that both notes are the same level of credit risk). Thus, your 5% note will become less valuable to compensate for the market interest rate change. Conversely, if the market rate were to go down to 3%, you would then be able to sell your existing note for a premium.
Well, there you have it. I really knew more about the fundamentals than I thought I did before I enrolled at Stern. The most important concepts in an introductory finance course I learned from real world experience from a simple peer to peer lending system! No wonder I passed the proficiency exam for the introductory finance course here 
Related posts:
- Why Credit Cardholders’ “Bill of Rights” is a Misnomer for H.R. 627 That’s right, calling the new bill, H.R. 627, the Credit...
