How financial markets (should) work

1

2

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.

3

◼ Three fundamental goals

Financial markets are called efficient as they achieve

• Market equilibrium: demand of funds equals supply; at the prevailing market conditions, everyone can freely lend or borrow as much as wanted (no "rationing")

• Allocation efficiency: allocation of funds is the best possible one (minimal cost, maximal benefit, for each agent, and society as a whole)

• Information efficiency: the market transmits all the necessary information to achieve efficient allocations.

4

◼ Three necessary conditions

Efficiency occurs with three necessary conditions • perfect competition -- free entry/exit

− no dominant position (no price makers)

• no transaction costs − transactions requires no extra cost (material or immaterial) in addition to the market cost

• perfect information − all operators are freely and equally endowed with "all relevant information" (to optimal decisions)

general (economy-wide) specific (sectoral) External information

All external factors affecting the payoffs of financial transactions

Internal information

All internal factors (specific to the parties) affecting the payoffs of financial transactions "characteristics" and "actions" of the borrower market conditions (security prices, interest rates)

5

◼ Supply and demand of funds

Let us start from the first fundamental function of financial markets: allow people to borrow and lend. Remember that this amounts to choosing the preferred time profile of resources and expenditure, and this is an intertemporal choice.

The general principle is that this choice (as any rational choice) is driven by comparing its cost with its benefit. The optimal choice should have benefit (at least) equal to cost.

6

•

Supply of funds

Consider a person with available resources in two periods Y0, Y1.

Y0 can be spent currently (E0) or lent (L0) at the year interest rate r. A supplier shifts

available resources from the present to the future. Time profile of available resources: E0 = Y0 − L0

E₁ = Y₁ + L₀(1 + r)

L

Supply curve

r

• 1+r measures the increase of future

resources (benefit) for €1 of decrease of

present resources (cost)

• Along the supply curve, the lender equates the benefit with the cost of lending. A higher 1 is an incentive to increase the supply of funds

7

•

Demand for funds

Y0 can be increased by borrowing (B0) at the year interest rate r.. A borrower shifts

available resources from the future to the present. Time profile of available resources: E0 = Y0 + B0

E1 = Y1 − B0(1 + r)

r

• 1+r measures the decrease of future

resources (cost) for €1 of increase of

present resources (benefit)

• Along the demand curve, the borrower equates the benefit with the cost of borrowing. A higher r is an incentive to decrease the demand for funds

B

Demand curve

8

◼ Market equilibrium

Market equilibrium obtains when demand equals supply at a single interest rate (market interest rate). No transaction takes place at a different rate

Market equilibrium Amount of funds r Market interest rate Demand _Supply r*

At the market interest rate,

• each borrower/lender in the market can make his optimal transaction

• borrow/lend the exact amount of funds that equates cost and benefit for each

• any single borrower/lender can satisfy his/her plan (no shortages)

9

•

The market mechanisms

The adjustment of the market out of equilibrium

Funds r Funds r S D

r is too high: excess supply;

supply (point A) exceeds demand (point B); suppliers' competition makes i fall up to equilibrium E

(note movements along the curves)

E

r is too low: excess demand;

(point A) exceeds supply (point B); demanders' competition makes i rise up to equilibrium E (note

movements along the curves)

A B E A B D S

10 The adjustment of the market: shifts of demand and supply

Funds

r

Funds

r increase in demand (D1) (the

curve shifts upw.): at the initial equilibrium rate E, D1 > S;

demanders' competition makes i rise up to equilibrium E1 (note the

movement along the supply curve)

E1

r increase in supply (S1) (the

curve shifts upw.): at the initial equilibrium-um rate E, S1 > D; suppliers' competition makes i fall up to equilibrium E1 (note the

movement along the demand curve)

D=S E E S=D D1 S1 E1 S D r S D

11

•

Solvency

In equilibrium, all borrowers must be solvent (solvency or intertemporal constraint) Bo(1+r) <Y1-E1

12

◼ Introducing security prices

We know that some financial instruments ("securities") are traded at a price in organized markets. In these markets, transactions modify the price of the security. We know that the interest rate on these instruments should be computed in a particular way − the rate of return − that takes the role of price into account. How does the security market mechanism work?

Rate of return of Italian Bonds and a Stock Index in 2015

13

•

The rate of return

Remember the formula of the RR of any security k

1 1 1 kt kt

1

y

p

r

p

=

+

−

− _pkt = purchase price at time t

− _{pkt+1 = market price at time} t+1 (e.g. one year);

− _{ykt+1 = payments (per euro) per time unit (a fixed interest rate} i for bonds, a variable _{dt+1 dividend for equities)}

•

Capital gains and losses

The formula can also be expressed as follows

1 1 1 1 1

=

y

p

p

r

p

p

y

p

p

−

=

+

+ 

rate of change of the price

- capital gain > 0 - capital loss < 0

14

•

The future value

Another formulation is the following: The sum of the payments and the future market price yield the future value of the security

Vkt+1 = ykt+1 + pkt+1 Therefore, 1 1 kt

1

V

r

p

=

−

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

Note. The formula of the RR has the simple meaning that you invest €_pkt to get €_{Vkt+1 in}

15 The relationship between the RR and the price of a security

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%.

rk

pk

higher V

lower 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