ASSET MARKETS

ASSETS
• An asset is a commodity that provides a flow of
services over time.
• E.g. a house, or a computer.
• A financial asset provides a flow of money over
time -- a security.
ASSETS
• Typically asset values are uncertain.

• Incorporating uncertainty is difficult at this stage

so we will instead study assets assuming that we
can see the future with perfect certainty.
SELLING AN ASSET
• Q: When should an asset be sold?
• When its value is at a maximum?
• No. Why not?
SELLING AN ASSET
• Suppose the value of an asset changes with time
according to
 Value
SELLING AN ASSET

Year
s
SELLING AN ASSET

Maximum value occurs when

That is, when t = 50.

 Value
SELLING AN ASSET

Max.
value
of $24,000
is reached
at year 50.

Year
s
SELLING AN ASSET
• 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.
• E.g. if an asset valued at $1,000 earns $100 then
its rate-of-return is 10%.
SELLING AN ASSET
• Q: Suppose the interest rate is 10%. When
should the asset be sold?
• A: When the rate-of-return to holding the asset
falls to 10%.
• Then it is better to sell the asset and put the
proceeds in the bank to earn a 10% rate-of-return
from interest.
SELLING AN ASSET
The rate-of-return of the asset at time t is

In our example,

so
SELLING AN ASSET
The asset should be sold when

That is, when t = 10.

 Value
SELLING AN ASSET

Max.
value
slop of $24,000
e is reached
= 0.1 at year 50.

Year
s
SELLING AN ASSET
• What is the payoff at year 50 from selling at year
10 and then investing the $8,000 at 10% per year
for the remaining 40 years?
SELLING AN ASSET
• What is the payoff at year 50 from selling at year
10 and then investing the $8,000 at 10% per year
for the remaining 40 years?
SELLING AN ASSET

So the time at which an asset should be

sold is determined by

Rate-of-Return = r, the interest rate.

ARBITRAGE
• Arbitrage is trading for profit in commodities which
are not used for consumption.

• E.g buying and selling stocks, bonds, or stamps.

• .No uncertainty ⇒ all profit opportunities will be

found. What does this imply for prices over time?
ARBITRAGE
• The price today of an asset is p0. Its price
tomorrow will be p1. Should it be sold now?
• The rate-of-return from holding the asset is

I.e.
ARBITRAGE
• Sell the asset now for $p0, put the money in the
bank to earn interest at rate r and tomorrow you
have
ARBITRAGE
• When is not selling best? When

• I.e. if the rate-or-return to holding the asset

the interest rate,
then keep the asset.
• And if then

so sell now for $p0.

ARBITRAGE
• If all asset markets are in equilibrium then
for every asset.
• Hence, for every asset, today’s price p0 and
tomorrow’s price p1 satisfy

• The equilibrium condition can also be stated as

no arbitrage condition.
ARBITRAGE

I.e. tomorrow’s price is the future-value of

today’s price. Equivalently,

I.e. today’s price is the present-value

of tomorrow’s price.
ARBITRAGE IN BONDS
• Bonds “pay interest”. Yet, when the interest rate
paid by banks rises, the market prices of bonds
fall. Why?
ARBITRAGE IN BONDS
• A bond pays a fixed stream of payments of $x per year,
no matter the interest rate paid by banks.
• At an initial equilibrium the rate-of-return to holding a
bond must be R = r’, the initial bank interest rate.
• If the bank interest rate rises to r” > r’ then r” > R and
the bond should be sold.
• Sales of bonds lower their market prices.
TAXATION OF ASSET RETURNS
• 2 kinds of asset returns are taxed :a) dividend or
interest return b) Capital gains
• rb is the before-tax rate-of-return of a taxable asset.
• re is the rate-of-return of a tax exempt asset.
• t is the tax rate.
• The no-arbitrage rule is:
(1 - t)rb = re
• I.e. after-tax rates-of-return are equal.
FINANCIAL INTERMEDIARIES
• Banks, brokerages etc.
● facilitate trades between people with different levels
of impatience
● patient people (savers) lend funds to impatient people
(borrowers) in exchange for a rate-of-return on the
loaned funds.
● both groups are better off.