Notes on the Pricing of Stocks, Bonds, and other Assets These notes describe some simple models for understanding fluctuations in the prices of stocks, bonds, and other types of assets. We will start with some definitions: Definitions A stock is ownership in a corporation. A share of stock entitles you to a proportional fraction of the corporations dividends. Dividends are cash payments made to shareholders. For example, if you owned 10 percent of IBM, you would receive 10% of the dividends IBM ‘management chose to pay out. Stock ownership also gives you a voice in how the corporation is managed. Shareholders vote on corporate matters, and the number of votes you get is equal to the number of shares of stock you own. These shares can be bought or sold on stock markets known as stock exchanges A Bond is a promissory note - it is a loan made by you to an organization - it could be a business or a government. You lend money to the organization, and they pay you back with interest. The loan can in principle be for any length of time, Thus, we can see one-period bonds, two-period bonds, etc. Notation: We will denote the price of any asset as P;. Thus, the price of stock today will be Pst. The price of a one-period bond today is Piz, the price of a two-period bond today is Pag, ete. We will denote the dividend for a stock today as D,,. We will denote the cash payment from a bond today as Dar. Now will we define a key concept, which is the return, and the rate of return on an asset. I will call these R, and r, repsectively: The return on any asset between date t and date t+1 is the ratio of the price at date t+1 and the payment from the asset at date t+1 divided by its price today: Rygy = Pur Dor The rate of return is just the return, minus 1: rit = Riv - 1‘The Basic Asset Pricing Formula ‘What determines the price of a stock, bond, or other asset? Why is the Microsoft corporation worth more than General Mills? Why did the value of Microsoft shares fall so much after Microsoft was found guilty of acting as a monopolist? These questions can be simply addressed using basic asset pricing theory. First, we will present in words, the basic asset pricing model. Then we will present it as an equation. In words, the basic models says that the marginal cost of acquiring the asset is equal to the marginal benefit of acquring the asset. ‘The details of this depend a bit on investor attitudes towards risk. We will not go into a lot of detail, about this, but focus on the case known as risk neutrality. For this case, investor's don’t care about the riskiness of the asset, which makes setting the equation up very easy. In this case, the marginal cost of acquiring the asset is just its price. The marginal benefit of acquiring the asset is the present value of what you expect it to deliver to you tomorrow. This marginal benefit is just your forecast of the asset's price tomorrow, plus your forecast of the asset’s cash payment, both discounted by the interest rate. The basic asset pricing equation thus becomes: Py = Piet Dies Ter Here, we denote the forecast of the price tomorrow as P%,,, we denote the forecast of the cash payment tomorrow as D/,,, and we discount both of those variables by the interest rate, which we assume is constant (141). ‘We can manipulate this forecast a bit. One problem is that the price today depends on the expected price tomorrow. What we can do is substitute out for this expected price as follows. Suppose we re-write the basic equation as of date t+1. This just involves up-dating the time subscripts one period, and expressing the price at date t+1 as its forecasted value: pr, = Pisa + Dina Now, substitute out for Pf, in the first equation, using the second equation. If we do this, we get: py = e+ Dh aa T+rIf we continue to make these types of substitutions - that is, substitute out for the future forecasts of the expected price, we will get: P, = Dis 4 Dia, Diss, l+r" (+r? ” (+r)? This equation thus says that the price of the asset - that is, the amount you are willing to pay for it - is just equal to the present value of all the expected future cash payofis. This makes sense - you won't pay more for something than what it will provide you — and what does an asset provide you? It gives you cash payoffs in the future. Now we can use the basic equation to value some assets. Example 1: What is the price of an asset that is gauranteed to pay off $1 tomorrow, but that has no other payofis in the future. Assume that the interest rate is 10 percent ‘The basic equation says: Di. Di, Di, = Sib 4 ie Pom Tih + Gis + Cs + We know Df, = 1, and that (141) = 1.10. We also know that all the future payoffs are zero. So we have: DE, = Po 2 $1. Pum Ter ~ Tag ~ $091 This particular asset is called a one-period bond, with a gauranteed payment of $1. Example 2: Suppose we have an asset that is gauranteed to pay off $1 tomorrow and $1 the next period, but no payoffs after that, Assume again the interest rate is 10 percent. Our equation now says: Diy, Dé, = Pwr , Pie _ $1, SI _ Pu= Ter * Tan? ~ 140 * T10r ~ 8174 This particular asset is called a two-period bond, with gauranteed payments of $1 in both periods. Example 3: Suppose we have an asset with an uncertain payoff. That is, suppose that thereisa 50 percent chance it pays off $1 tomorrow, and a 50 percent chance there is no payoff. So now we need to form a forecast of the payoff tomorrow. We do this by forecasting the average payoff we expected to get, which is just a weighted average over all the possible payoffs, and the weights are equal to the probabilities of each possible payoff. Our forecasting rule therefore is to just take the 2 possible payoffs, and multiply each by the probability that the payoffs occur. In this case, there is a 50 percent chance of each possible payoff, so we have: Dh, = 5*$1+.5*0=$.50 Assuming that the interest rate remains at 10 percent, the price for this particular asset is given by: Di, = Din - $50 _ Pa = pith = $50 = $0.45 Example 4: Suppose we have an asset in which there is a 95 percent chance it pays off $1 tomorrow, and a 5 percent chance it pays off $1,000. The steps are similar as above: we first need to make a forecast of the average payoff. Our forecast for the expected payoff is: Diu, = 95 * $1 +.05 «$1,000 = $50.95 Given an interest rate of 10 percent, then the price is: Py = Dish = $50.95. _ 546,32 ae 1.10 Thus, the price that you would expect to pay for an asset that with a.95 percent chance pays off $1 tomorrow, but with a 5 percent chance pays off $1,000 tomorrow, is $46.32, (given an interest rate of 10 percent).