HOW FINANCIAL MARKETS WORK

Efficient markets In this part we begin the study of the key working mechanisms of financial markets. Actual markets are very complex entities, and how they work essentially depends on a number of specific characteristics concerning the structure of the market and the operational conditions of participants. Here we begin with a set of characteristics that qualify financial markets as efficient (the so-called Efficient Market Hypothesis (EMH)). Efficiency is a key concept of modern finance. It relates to general economic principles of efficient allocation of resources, in the particular context of financial resources.

Efficiency occurs with three necessary conditions perfect competition no transaction costs perfect information free entry/exit no dominant position (no market makers) transations requires no extra cost (material or immaterial) in addition to the market cost all operators are freely and equally informed about the prevailing market conditions (the market interest rate) at any point in time

Efficient financial markets achieve three fundamental properties: market equilibrium: demand of financial funds equals supply allocative efficiency: allocation of funds is optimal = given the market interest rate each agent equates marginal cost and marginal benefit of funds solvency: all those who are funded are solvent.

1. Supply, demand, equilibrium

Supply and demand of funds Let us start from the first fundamental function of financial markets: allow people to choose their preferred time profile of resources and expenditure (intertemporal problem) Consider a person with available resources in two periods Y0, Y1 Supply of funds: Y0 can be spent currently (E0) or lent (L0) at the year interest rate (or return rate) r. Time profile of available resources: E0 = Y0 L0 E1 = Y1 + L0(1 + r) A supplier shifts resources from the present to the future.
L Supply curve 1+r measures the increase of future resources for 1 of decrese of present resources. A higher r is an incentive to increase the supply of funds

Demand of funds: Y0 can be increased by borrowing (B0) at the year interest rate r. Time profile of available resources: E0 = Y0 + B0 E1 = Y1 B0(1 + r) A borrower shifts resources from the future to the present.
B Demand curve 1+r measures the decrease of future

resources for 1 of increse of present resources. A higher r is an incentive to decrease the demand of funds

Market equilibrium Market equilibrium obtains when demand equals supply at a single interest rate (market interst rate)
Market equilibirium

Amount of funds

Demand

Supply

Market interest rate

 The market mechanisms

The adjustment of the market out of equilibrium

Funds

Funds

S E D

D E S

r
r is too high: excess supply; supply (point S) exceeds demand (point D); suppliers' competition makes r fall up to equilibrium E (note movements along the curves)

r is too low: excess demand;denmand (point D) exceeds supply (point S); demanders' competition makes r rise up to equilibrium E (note movements along the curves)

The adjustment of the market: shifts of demand and supply

Funds

Funds E1 E

D1 S=D

S1 D=S

E1 E

r
increase in demand (D1) (the curve shifts upw.): at the initial equilibrium rate E, D1 > S; demanders' competition makes r rise up to equilibrium E1 (note the movement along the supply curve)

increase in supply (S1) (the curve shifts upw.): at the initial equilibrium rate E, S1 > D; suppliers' competition makes r fall up to equilibrium E1 (note the movement along the demand curve)

 Solvency
In equilibrium, all borrowers must be solvent (solvency or intertemporal constraint) B0(1 + r) < Y1 E1 Y E1 B0 1 (1 + r ) Borrowing must not exceed the present value of net future resources

2. Security markets and prices

Introducing security prices Some financial instruments ("securities") whereby funds are exhanged are traded at a price in organized markets. We know that for these instruments we should compute the rate of return (which may or may not include a fixed interest rate). In these markets transactions modify the price of the security. How does the security market mechanism work? Remember the formula of the return rate (RR) of any security k pkt = purchase price at time t pkt +1 pkt = capital gain/loss pkt+1 = market price at time t+1 (e.g. one year); pkt+1 = pkt ykt+1 = payoff (per euro) per time unit (a fixed interest rate i for bonds, a variable dt+1 dividend for equities)

ykt +1 + pkt +1 rkt +1 = 1 pkt

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 The sum of the payoff and the future market price is the future value of the security, Vkt+1 = ykt+1 + pkt+1 Therefore,

rkt +1 =

Vkt +1 1 pkt

The RR of a security is inversely proportional to its price, for its given future value
The relationship between the RR and the price of a security

RR
higher V

V determines the position of the curve. Given the price, higher (or lower) V shifts the curve upw. (or downw.) and raises (or lowers) the RR

lower V

price

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Example. The current price of the shares of company k is pkt = 2. The one-year dividend is dkt+1 = 0.2 per share, and the resale price is pkt+1 = 2.1. Hence, Vkt+1 = (0.2+2.1) = 2.3, and rkt+1 = (2.3 2)1= 0.15 = 15%. Now suppose that i) the price falls to 1.8. Hence rkt+1 = (2.3 1.8)1= 0.278 = 27.8% ii) at the initial price, the one-year dividend is revised downwards to dkt+1 = 0.1. Hence, Vkt+1 = 2.2, rkt+1 = 10% Demand and supply w.r.t. price We can now translate demand and supply of funds into demand and supply of securities. First, consider that those who demand funds:

those who supply funds:

issue (supply) securities demand for funds is decreasing in the RR RR is decreasing in the security price security supply is increasing in its price buy securities demand for funds is increasing in the RR RR is decreasing in the security price security demand is decreasing in its price
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Demand and supply of a security

amount of security k demand d

amount of security k supply demand d E1 equilibrium price equilibrium RR E supply

price
Exercise. Draw an increase in the demand for the security, and determine the new equilibrum price. How has the RR changed? Do the security suppliers receive more or less funds than before?

price
How to get more funds from the market. Suppose k is a bond issued by a company, and at the equilibrium price E, the company wishes more funds. Its supply of k should increase (the supply curve shifts upw.). The market accepts to buy the new issuance of k at the new equilibrium price E1, such that the RR of k is higher
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Arbitrage across securities Can the RR of any security be set independently of (and be different from) the RR of other securities?. In an efficient market the answer is NO. Let us use the EMH perfect competition no transaction costs perfect information

reformulated as follows: all operators are all freely and equally informed about the prevailing market conditions (the RRs of all securities), i.e. they posses the "information set" {Vkt+1, pkt, all k} at any point in time t.

Under these conditions fund suppliers compare the RRs across securities and seek higher RR. They sell low RR and buy high RR assets. This is called arbitrage.

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 Consider the following process higher RR securities lower RR securities demand increases demand decreases price rises price falls RR falls RR rises

Arbitrage tends to make RRs convergent, and in force of efficient arbitrage, security trading goes on until all securities pay a unique RR, the "market return rate" rt+1

Vkt +1 rkt +1 = 1 rt +1 pkt

The equilibrium (arbitrage) price of securities Security trading determines prices, not directly RRs. The price of each security that is established at the arbitrage equilibrium is

pkt =

Vkt +1 1 + rt +1

The equilibrium price of a security is the present value of its future market value (payoff + sale price) discounted with the market RR
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Relationship between security price and market return rate

pkt
high future value Securities with higher future value command a higher price than those with lower future value

low future value

rt+1 Example 1. The year market RR is 5%. The stock company k has a prospective profit of 100 mln. and a sale price of 2 bln. Profits are entirely distributed to shareholders. Its present market value is pkt = (2.1 bln 1.05) = 2 bln. 2 bln divided by the number of shares gives the market price of equities k. The market RR rises to 7%: check that pkt falls to 1.97 bln.

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Example 2. News and prices. Consider again Example 1. i) News arrive that raise the prospective profits of the company to 150 mln. The future value is now 2.15 bln., and hence the present market value rises to 2.05 bln. In fact, at the initial value of 2 bln., holding the shares of k would yield more than the market rate, rkt+1 = (2.15 bln./2 bln) 1 = 7.5%. Arbitrage shifts demand towards shares k and raises their price until the RR is 5% again. ii) At the initial market value of 2.0 bln., company k has 100 mln. shares of 20 each in the market. News arrive that their price will rise by 10% on a year basis. Hence the current price rises to 22.1 (compute this by means of the formula of pkt applied to unit values per share).
A trading day of "Telecom Italia" at the Milan Stock Exchange

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3. Fundamental valuation
We have seen that, givent the market RR, th equilibrium price of a security depends on its future value. This is typically a forecast based on available information The future value of a security is given by its prospective payoff as well as its future price. What is the economic rationale of having the present price to depend on the future price? How can the future price be forecast?

The Rational Expectations Method (REM) The REM is a sophisticated method that explains how forecasts of future variables can be obtained in a rational manner, where "rational" means to make the best use of all available knowledge and information to obtain a (statistically) correct forecast (not systematically wrong, correct "on average")

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 Consider again the equilibium security price formula in a simple reformulation

pkt =

1 1 ykt +1 + pkt +1 = PV of next payoff + PV of next price 1+ r 1+ r

As a first approximation the market RR is taken as a constant r. To determine pkt+1, use "all available knowledge", i.e. "the model" that generates the price. Hence project the formula into the future,

Back to the present

1 1 ykt + 2 + pkt + 2 1 + rt 1 + rt 1 1 1 1 pkt = ykt +1 + ykt + 2 + pkt + 2 1+ r 1+ r 1+ r 1+ r 1 1 1 = ykt +1 + ykt + 2 + p 2 2 kt + 2 1+ r (1 + r ) (1 + r ) pkt +1 =

Now pkt depends on pkt+2, the price two years hence. If you repeat the operation with pkt+2, you will get that pkt depends on pkt+3, and so on. This is an "infinite regress" problem. How can it be solved?

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 At the Tth period forward, the fomula looks like the following

pkt =

n =1

(1 + r )
1

ykt + n +

1 (1 + r )
T

pkt +T

Note that the discount factor 1/(1 + r)T tends to zero as time T grows to infinity, so that the future price term vanishes. Therefore,

pkt = n

(1 + r )

ykt + n

Under the REM, the equilibrium price of a security is the compound present value of the sum of all its future payoffs ("intrinsic" or "fundamental" evaluation)

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Conclusion Arbitrage + Equilibrium pricing + REH = "fundamental" evaluation = Informational Efficiency Fundamental evaluation implies that only all future payoffs matter (no conjectures or "speculations" about future prices). Indeed, payoffs measure the intrinsic income generation of the asset. Hence proposition of Informational Efficiency (the mkt. price of an asset reveals all is necessary for lenders to know) Relatedly, efficient prices only react to unexpected news about future payoffs. Therefore, efficient prices move randomly. A random walk is a process such that pkt = pkt-1 + ut where ut is a random variable unpredictable at t-1, and is uncorrelated with previous or future random news. In other words, pkt-1 contains all value information as of t-1, but it contains no information about pkt. In an efficient financial market, the best predictor of the future price of an asset is its current price

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