Total Debt + Total Equity = Constant K

Cedric:Whats wrong with that picture?Absolutely nothing
1) Assets = Liabilities and2) Assets = Liabilities + Owner’s Equityare both exactly the same equation.In some texts 1) is written because Owner’s Equity is also defined as a ‘Liability ‘ which is from the Corporation as a Legal Entity to the investor.Cedric I don’t know how sensitive this point might be but when you buy a stock for $200 and it falls to say $100; you sell the stock and you had a loss of $100.One man’s equity loss is another’s gain.Clueless reporters mention things like ‘the market crashed 7% eroding xyz gazillions in ‘investor wealth’.A crashing equity market only means that there’s an overall movement from equity to debt instruments (debt here includes deposits with banks).If you assume a simple world where people only have stocks, bonds and checking accounts:Stocks + Bonds + Checking Accounts = Constant KNote that this reasoning applies only in this assumed simple world. As you complicate things with more and more financial instruments, you will still getTotal Equity + Total Debt = Constant KNote that Equity has a risk + return profile which comes directly from variability of business returns.Debt has a risk + return profile which comes from credit risk; and in the ultimate analysis credit risk is simply another form in which the risk of business returns is expressed, apart from the issue of simple trust.Financial engineering provides the ability to create various risk + return profiles beginning from your simple world of stocks, bonds and checking accounts.So you can have instruments which start with credit risk in a debt instrument and create an ‘equity rated’ instrument which has a higher risk + return profile.Similarly you can start with a lower risk + return profile stock and create an equity option which has a much different risk + return profile than the stock.In terms of flows, you can create instruments which provide an initial cash inflow, while exposing you to theoretically unlimited outflows, such as for example short positions in call options.No matter how much you alter the risk + return profile of instruments, your original equationTotal Equity + Total Debt = Constant KStill holds.Coming to the point of some instruments which are ‘off balance sheet’ you’re just saying that from the perspective of one entity those assets are off their balance sheet but those instruments are still reflected in another balance sheet somewhere else.