1. Chapter Eleven Asset Markets

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

3. Assets u Typically the values of assets are uncertain. But incorporating uncertainty is difficult at this stage so we will instead study assets assuming that we can see the future with perfect certainty.

4. Selling An Asset u 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. u For example, if an asset valued at $1,000 earns $100 then its rate-of- return is 10%.

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

6. Arbitrage u Arbitrage is trading for profit in commodities which are not to be used for consumption. u For example, buying and selling stocks and bonds, or stamps. u Since there is no uncertainty, all profitable opportunities should be located by arbitrageurs -- what does this imply for prices over time?

7. Arbitrage u Suppose the price of an asset today is p 0 and that its price tomorrow will be p 1. Should it be sold now? u The rate-of-return from holding the asset is which rearranges to

8. Arbitrage u What if instead you sold the asset now for $p 0 and put the money in the bank to earn interest at rate r ? u Then tomorrow you would have

9. Arbitrage u When is not selling best? When So if the rate-or-return to holding the asset exceeds the interest rate then the asset should be kept. u And if then and it is best to sell now for $p 0.

10. Arbitrage u So, if all markets for financial assets are in equilibrium we must have that for every asset.

11. Arbitrage in Bonds u Bonds are said to “pay interest”. Yet, when the interest rate paid by banks rises, the market prices of bonds fall. Why is this?

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