1. Chapter 11 Asset Markets
Key Concept: no arbitrage.

2. Chapter 11 Asset Markets
Assets are goods that provide a flow of services over time
consumption services (housing, art work)
monetary flow (financial asset such as bond)
Are you (your cats) an asset to your family?

3. Assume complete certainty about the future flow of services in this chapter.

4. How is the return of an asset determined?
Two asset
A: p0 today and p1 next year
B: 1 dollar today and 1+r next year

5. In equilibrium for both assets to be held, it must be 1+r= p1 / p0.
Why?

6. A: p0 today and p1 next year
B: 1 dollar today and 1+r next year
If 1+r>p1 / p0, A holder will sell asset A now and invest in asset B.
This gives him p0(1+r) > p1.
This is called arbitrage.

7. p0(1+r) > p1.
Since everyone wants to sell A and no one wants to buy A, the supply of A is greater than the demand. This is not an equilibrium.
It pushes p0 to go down so that the return on asset A becomes higher.

8. You can imagine the other side of the story when 1+r<p1 / p0.
In equilibrium since the returns on A and B are equal, there is no chance to arbitrage.

9. One adjustment regarding assets with consumption returns.
A house today costs P dollars, but next year, it can sell for P+a dollars.
a is the appreciation (depreciation) of the house. So should the return rate of a house be a/P?

10. If you buy a house, you can rent the house to someone else.
Suppose the rent is R a year.
Then the rate of return should be (a+R)/P.
By no arbitrage condition, r = (a+R)/P must hold in equilibrium.

11. Assets like art objects have this similar property.
R could be the dollar value of being able to enjoy the art for a year.
So the return in financial terms can be lower.

12. Some application of the no arbitrage principle.
Extracting oil

13. Zero extraction cost.
The demand for oil is constant at D barrels per year and there is a total supply of S barrels.
So we have a total of T=S/D years of oil left.
The perfect substitute of oil will come at T years after and it will sell at C dollars per barrel.

14. In equilibrium, it must be pt+1=(1+r)pt for there to be a positive amount supplied every year.
Why? Oil in the ground is like money in the bank. You always invest in the one with a higher return. Hence in equilibrium their returns have to be the same.

15. If oil in the ground earns less than money in the bank, oil owner will pump out oil immediately in order to put money in the bank. This will lead to a price decrease of oil, driving up the return.
If oil in the ground earns more than money in the bank, oil owner will not take oil out of the ground. This will lead to a price increase of oil, driving down the return.

16. At T years after, the price per barrel must be c. Hence p0(1+r)T=C
Hence, unforeseen new discovery of oil will increase T and decrease p0.
On the other hand, a decrease of C will decrease p0.

17. Another application is on when to cut a forest.
The lumber that you get from a forest F(t).
The growth rate of tree starts high and gradually declines.

18. When to cut the trees? The forest grows just like money in the bank grows. Hence we should cut at T:
F(1)/F(0)>1+r, F(2)/F(1)>1+r, …, F(T)/F(T-1)≥1+r, F(T+1)/F(T)<1+r, so at any point of time, you save your money in the bank that pays the highest, either in a financial bank or in a “tree” bank.
You cut the trees at T.

19. In 1990 Iraq invaded Kuwait. As a response, the UN imposed a blockade on oil imports from Iraq. Price of gasoline immediately went up.
War profiteering? (A blockade on oil imports due to some war, price of oil immediately goes up.)

20. Opportunity cost: If you can sell at 1
Opportunity cost: If you can sell at 1.5 per gallon 6 weeks from now, you would be foolish to sell at much less than 1.5 per gallon now.
Moreover, it makes sense to start consuming less today and to try inventing alternatives.
This is just like the stock market. Market reacts at the time the information about a future event is known. It won’t wait till the time the future event is realized.

21. Asset markets allow people to change their pattern of consumption over time.
Old people may have a lump sum and would like to have a stream of payments while young may have a stream of payments but want a lump sum now. (bank)
Entrepreneurs need cash now to start off and will pay back in the future. Investors invest now and get paid back in the future. (stock market)

22. Chapter 11 Asset Markets
Key Concept: no arbitrage.