Chapter 14: Asset Markets
3. Functions of Asset Markets
Financial intermediaries = financial intermediaries channel resources from savers to
borrowers and investors.
The yield curve shows how the interest rates vary by maturity. Interest rates rise as the
maturity increases. Interest rate on the y-axis, maturity on the x-axis.
For the lender, a longer maturity means that it will take more time to recover the money; it
makes sense to ask for a higher interest rate to compensate for being locked in. the
borrower is willing to pay such a maturity premium because the funds will remain longer at
their disposal.
A basic rule of financial markets: obvious profit opportunities are quickly eliminated by the
action of market participants. This is the no-profit condition, which implies that equivalent
financial operations carry the same interest rate or bear the same rate of return.
Diversification = the holding of a mix of several different assets to insure against financial
uncertainty. Doing so dilutes the impact of any bad outcome by mixing a few risky assets.
Risk can be reduced, but cannot be fully eliminated. The way to induce people to bear risk is
to compensate them for it. This compensation is called a risk premium.
4. Asset Prices and Yields
The no-profit condition implies that, at any moment of time, a bond’s current price must
represent the present value of all the payment sot which the bond’s owner is entitled.
Consol = the ‘ultimate bond’, it exists forever, its maturity is infinite. Such a bond is also
called a perpetuity. P = C/i
A one-year bond with face value F that sells for price P implies a rate of return i = (F/P) – 1.
Stocks
A share in a company gives rise to the payment of dividends, a portion of profits. Let us
denote by dt the dividends paid at the end of period t. The shareholder does not just receive
dividends. The value of the share that hey hold can increase or decrease. If qt is the real
share price at the beginning of period t, the rate of return on the company share is the
dividend yield, dt/qt, plus the anticipated capital gain, (qt+1 -qt)/qt (a gain if qt+1>qt a loss if qt+1
< qt).
For simplicity, we will start by treating the future price qt+1 as known with certainty and
abstract from risk. The no-profit condition implies that both assets have the same yield over
period t: r = dt/qt + (qt+1 – qt)/qt
Yield on safe bond = dividend yield + capital gain (which together is total return on shares)
Rewritten gives: qt = dt + qt+1
1+r Todays’ stock price is equal to the PDV of the dividend.
3. Functions of Asset Markets
Financial intermediaries = financial intermediaries channel resources from savers to
borrowers and investors.
The yield curve shows how the interest rates vary by maturity. Interest rates rise as the
maturity increases. Interest rate on the y-axis, maturity on the x-axis.
For the lender, a longer maturity means that it will take more time to recover the money; it
makes sense to ask for a higher interest rate to compensate for being locked in. the
borrower is willing to pay such a maturity premium because the funds will remain longer at
their disposal.
A basic rule of financial markets: obvious profit opportunities are quickly eliminated by the
action of market participants. This is the no-profit condition, which implies that equivalent
financial operations carry the same interest rate or bear the same rate of return.
Diversification = the holding of a mix of several different assets to insure against financial
uncertainty. Doing so dilutes the impact of any bad outcome by mixing a few risky assets.
Risk can be reduced, but cannot be fully eliminated. The way to induce people to bear risk is
to compensate them for it. This compensation is called a risk premium.
4. Asset Prices and Yields
The no-profit condition implies that, at any moment of time, a bond’s current price must
represent the present value of all the payment sot which the bond’s owner is entitled.
Consol = the ‘ultimate bond’, it exists forever, its maturity is infinite. Such a bond is also
called a perpetuity. P = C/i
A one-year bond with face value F that sells for price P implies a rate of return i = (F/P) – 1.
Stocks
A share in a company gives rise to the payment of dividends, a portion of profits. Let us
denote by dt the dividends paid at the end of period t. The shareholder does not just receive
dividends. The value of the share that hey hold can increase or decrease. If qt is the real
share price at the beginning of period t, the rate of return on the company share is the
dividend yield, dt/qt, plus the anticipated capital gain, (qt+1 -qt)/qt (a gain if qt+1>qt a loss if qt+1
< qt).
For simplicity, we will start by treating the future price qt+1 as known with certainty and
abstract from risk. The no-profit condition implies that both assets have the same yield over
period t: r = dt/qt + (qt+1 – qt)/qt
Yield on safe bond = dividend yield + capital gain (which together is total return on shares)
Rewritten gives: qt = dt + qt+1
1+r Todays’ stock price is equal to the PDV of the dividend.
