Lecture 3: FMI

Asset Markets and Asset Prices

from
Economics of Financial Markets
• In the wake of financial liberalisation and
innovation, asset prices have become more
important factors in driving economic
fluctuations, allocating resources across
sectors and time and influencing the strength
of the financial system.
• Moreover, asset prices play various related
roles in the monetary policy/financial stability
frameworks.
• These roles include acting as sources of
information concerning market expectations
and markets’ risk attitudes, acting as leading
indicators of output, inflation and financial
distress, and acting as indicators of the shocks
that hit the economy.
• In recent years, policymakers have been
confronted with sometimes unusual
developments in asset prices, including strong
booms and busts, the exceptional strength and
breadth in the upswing in residential property
prices, historically low long-term interest
rates, and low volatility and very narrow credit
spreads.
• As a result, it has become more important to
understand what determines asset price
movements, to interpret the message they
contain about the future and to incorporate
them into policy decisions.
 Financial Markets

• Financial markets facilitate the exchange of

assets.
• Central to an understanding of finance is the
process of arbitrage.
• Arbitrage trading policies seek, essentially, to
exploit price discrepancies among assets.
 Capital Markets
 Functions of financial systems:
1)Clearing and settling payments
2)Pooling resources and subdividing shares
3)Transferring resources across time and
space
4)Managing risk
5)Providing information
6)Dealing with incentive problems
 List of Financial Markets:
1)Equity or Stock Markets
2)Bond Markets
3)Money Markets
4)Physical Asset Markets (Mortgage)
5)Foreign Exchange Markets
6)Derivatives Markets:
a) Futures (Trade on exchange)
b) Forward agreements (Trade on OTC)
c) Options
Asset Price Determination: An Introduction

A single asset market

 Economic theory of supply and demand of price
determination applies to asset markets.
 Asset prices more flexible than volume of assets
 Market price adjusts so that wealth holders hold
the existing stock.
 In some cases, total stock of existing assets treated
as Zero (volume of purchases equals sales).
 Q: what determines the demand to hold the asset?
 A: a) preferences, b) prices, and c) income
Multiple asset markets: a more formal
approach
 Q: What are the forces determining market prices
of different assets?
 Assume many investors with initial wealth, each is
a price taker. Select portfolio according to the
decision rule: number of assets to hold as a
function of observed prices and initial wealth.
 Market equilibrium is defined by a set of asset
prices and an allocation of assets among investors
that satisfy the following conditions.
1) Each portfolio is determined according to the
decision rule.
2) Demand equals supply
 Some investors are allowed to hold negative amounts
of assets
3) At each instant of time total asset stocks are
given.
4) Asset prices adjust so that existing stocks are
willingly held.
5) Asset stocks change with time. Also portfolios
change. As a result, prices change.
Rates of return

 Assets are held because they yield a rate of return:

Rate of Return ≡ payoff – Price

Price

 An asset’s payoff have several components (e.g.

bonds, deposits, shares)
 Rates of return

 Asset’s rate of return between t and t+1 is:

yt+1 ≡ vt+1 – pt
pt
 Rate of return is measured by the
proportional rate of change of the asset’s
market value.
 Real rate of return = nominal rate –
inflation rate
The roles of prices and rates of return
 Most important aspect of R.O.R. for decision
making; they forward looking: they depend on
future payoffs (which are partly uncertain).

 Current market prices play two roles in Fin. Econ:

1) The price represents an opportunity cost.
2) The price conveys information.
 The price represents an opportunity
cost.
• An asset's price appears in the wealth
constraint as the amount that has to be paid, or
is received, per unit of the asset.
• This is the conventional role for prices in
economic analysis.
 The price conveys information.

• The price conveys information. Today's asset

price reveals information about prices in the
future.
 The Role of Expectations

 According to Keynes: asset prices affect

expectations, expectations affect decisions,
decisions affect prices.
 Thus, for a higher price today, investors
infer that the price will be higher tomorrow.
 This leads to greater demand to hold the
asset.
 The Role of Expectations

 In the presence of such extrapolative

expectations, demand curve could be
positively sloping.
 Investors are assumed to “Rational
Expectations”: expectations are formed
with awareness of forces that determine
market prices.
 Fischer Black (1986) introduced the concept
of noise to financial analysis.
 Some investors are assumed to act in
arbitrary ways that are difficult to explain
as the outcome of consistent behavior.
 These investors are called “noise traders”
 “Rational Traders” behave according to
more coherent rules and have better
information than noise traders.
 The noise-trader approach is part of
behavioral finance which exploits ideas
from outside economics, including
psychology.
 The acquisition and processing of
information by investors received limited
attention in fin. Econ.
 Each investor’s beliefs about assets’ payoffs
are predictions made from the investor’s
personal model of capital markets.
Performance Risk, Margins and Short-selling

Performance Risk and Margin Accounts

 Uncertainty about the future plays a central role in
economics and permeates every branch of financial
analysis.
 Price Risk: prospect that mkt. value of an asset
changes by an unknown amount in the future.
 Performance Risk: prospect that a contractual
obligation will not be fulfilled.
 Minimizing performance risk is made via deposits
in margin accounts: contracting parties agree to
deposit funds with a third party (Agents).
 Short-sales

 Selling short: the action of selling an asset

that the investor does not own.
 The asset is borrowed prior to the sale.
 The motive: at a date following the short-
sale, the asset will be purchased for a lower
price and returned to its lender.
 The short-seller then gains the difference
between the sale and purchase prices.
 Exchange authorities place restrictions on
the circumstances in which short-sales are
permitted.
 Only restricted group of investors permitted
to to engage in short sales.
 Arbitrage
The arbitrage principle
 Arbitrage Strategies: patterns of trade motivated
by the prospect of profiting from discrepancies
between the prices of different assets but without
bearing any risk.
 Observed market prices reflect the absence of
arbitrage opportunities.
 Arbitrage

 With arbitrage, investors could design

strategies that yield unlimited profits with
certainty.
 Arbitrage implies the law of one price.
 Financial theories are founded on the
absence of arbitrage opportunities.
Market frictions
 Transaction costs: fees, taxes, trade charges
 Implicit T.C.: difference between bid and ask
prices and time devoted to decision making.
 Institutional restrictions: prohibitions on
particular class of trades or conditions to be
fulfilled before trades are permitted.
 The assumption of frictionless markets underpins
the absence of arbitrage opportunities.
 Frictions do not necessarily impinge equally on all
market participants.
 1.7 Asset Market Efficiency
 The main types of efficiency are:
 Allocative efficiency (pareto efficiency)
 Operational efficiency (industrial
efficiency)
 Informational efficiency (asset prices as
reflections of inf. available to investors.)
 Portfolio efficiency (small return variance)
 Operational and informational efficiencies
are the most extensively used in fin. analysis