Chapter Eleven

Asset Markets

Assets
An

asset is a commodity that provides a flow of services over time. E.g. a house, or a computer. A financial asset provides a flow of money over time -- a security.

Assets
Typically

asset values are uncertain. Incorporating uncertainty is difficult at this stage so we will instead study assets assuming that we can see the future with perfect certainty.

Selling An Asset
Q:

When should an asset be sold? When its value is at a maximum? No. Why not?

Selling An Asset
Suppose

the value of an asset changes with time according to

V( t ) 1000 1000t 10t

Value
24000 19000 14000 9000 4000 -1000 0

Selling An Asset

10

20

30

40

50

60

Years

Selling An Asset
V( t ) 1000 1000t 10t
Maximum value occurs when

V'( t ) 1000 20t 0

That is, when t = 50.

Value
24000 19000 14000 9000 4000 -1000 0

Selling An Asset
Max. value of $24,000 is reached at year 50.

10

20

30

40

50

60

Years

Selling An Asset
The

rate-of-return in year t is the income earned by the asset in year t as a fraction of its value in year t. E.g. if an asset valued at $1,000 earns $100 then its rate-of-return is 10%.

Selling An Asset
Q:

Suppose the interest rate is 10%. When should the asset be sold? A: When the rate-of-return to holding the asset falls to 10%. Then it is better to sell the asset and put the proceeds in the bank to earn a 10% rate-of-return from interest.

Selling An Asset
The rate-of-return of the asset at time t is

V'( t ) . V( t )
In our example,

V(t ) 1000 1000t 10t .

2

so

V'( t ) 1000 20t 0 V'( t ) 1000 20t . V( t ) 1000 1000t 10t 2

Selling An Asset
The asset should be sold when

V'( t ) 1000 20t 01 V( t ) 1000 1000t 10t 2

That is, when t = 10.

Value
24000 19000 14000 9000 4000 -1000 0

Selling An Asset
Max. value of $24,000 is reached at year 50.

slope = 0.1

10

20

30

40

50

60

Years

Value
24000 19000 14000 9000 4000 -1000 0

Selling An Asset
Max. value of $24,000 is reached at year 50.

slope = 0.1

Sell at 10 years even though the assets value is only $8,000.

20 30 40 50

10

60

Years

Selling An Asset
What

is the payoff at year 50 from selling at year 10 and then investing the $8,000 at 10% per year for the remaining 40 years?

Selling An Asset
What

$8,000 (1 0 1)

is the payoff at year 50 from selling at year 10 and then investing the $8,000 at 10% per year for the remaining 40 years? 40

$362,074 $24,000

Selling An Asset
So the time at which an asset should be sold is determined by
Rate-of-Return = r, the interest rate.

Arbitrage
Arbitrage

is trading for profit in commodities which are not used for consumption. E.g. buying and selling stocks, bonds, or stamps. No uncertainty all profit opportunities will be found. What does this imply for prices over time?

Arbitrage
The

price today of an asset is p0. Its price tomorrow will be p1. Should it be sold now? The rate-of-return from holding the p1 p0 asset is

I.e.

p0

(1 R )p0 p1 .

Arbitrage
Sell

the asset now for $p0, put the money in the bank to earn interest at rate r and tomorrow you have

(1 r )p0 .

Arbitrage
When

is not selling best? When (1 R )p0 (1 r )p0 . I.e. if the rate-or-return to holding the asset R r the interest rate, then keep the asset. And if R r then (1 R )p0 (1 r )p0 so sell now for $p0.

Arbitrage
If

all asset markets are in equilibrium then R r for every asset. Hence, for every asset, todays price p0 and tomorrows price p1 satisfy

p1 (1 r )p0 .

Arbitrage
p1 (1 r )p0
I.e. tomorrows price is the future-value of todays price. Equivalently, p1 p0 .

1r

I.e. todays price is the present-value of tomorrows price.

Arbitrage in Bonds
Bonds

pay interest. Yet, when the interest rate paid by banks rises, the market prices of bonds fall. Why?

Arbitrage in Bonds
A

bond pays a fixed stream of payments of $x per year, no matter the interest rate paid by banks. At an initial equilibrium the rate-of-return to holding a bond must be R = r, the initial bank interest rate. If the bank interest rate rises to r > r then r > R and the bond should be sold. Sales of bonds lower their market prices.

Taxation of Asset Returns

rb

is the before-tax rate-of-return of a taxable asset. re is the rate-of-return of a tax exempt asset. t is the tax rate. The no-arbitrage rule is: (1 - t)rb = re I.e. after-tax rates-of-return are equal.

Financial Intermediaries
Banks,

brokerages etc. facilitate trades between people with different levels of impatience patient people (savers) lend funds to impatient people (borrowers) in exchange for a rate-of-return on the loaned funds. both groups are better off.