How financial markets (should) work

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 1. Efficient financial 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.

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◼ 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.

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◼ Three necessary conditions

Efficiency occurs with three necessary conditions

• perfect competition
• no transaction costs
• perfect information
-- free entry/exit
− no dominant position (no price makers)
− transactions requires no extra cost (material or
immaterial) in addition to the market cost
− all operators are freely and equally endowed with "all
relevant information" (to optimal decisions)

general
External information (economy-wide) Internal information
All external factors All internal factors "characteristics" and
specific "actions" of the
affecting the payoffs of (specific to the parties)
(sectoral) borrower
financial transactions affecting the payoffs of
market conditions financial transactions
(security prices,
interest rates)

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 2. Supply, demand, equilibrium

◼ 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.

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• 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 • 1+r measures the increase of future
curve 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 r is an incentive to
increase the supply of funds
r

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• 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)

B
Demand
• 1+r measures the decrease of future
curve
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
r

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◼ 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 Demand Supply
At the market interest rate,
• each borrower/lender in the market can
make his optimal transaction
Market interest • borrow/lend the exact amount of funds
rate that equates cost and benefit for each
• any single borrower/lender can satisfy
his/her plan (no shortages)

r* r

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• The market mechanisms

The adjustment of the market out of equilibrium

Funds Funds
D D
S
S
A
A
E E

B B

r r
r is too high: excess supply; r is too low: excess demand;
supply (point A) exceeds demand (point A) exceeds supply (point B);
(point B); suppliers' competition demanders' competition makes r rise
makes r fall up to equilibrium E up to equilibrium E (note
(note movements along the curves) movements along the curves)

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 The adjustment of the market: shifts of demand and supply

Funds Funds
D1
D D S1 S
S

E1 E1
E
S=D D=S E

r r
r increase in demand (D1) (the r increase in supply (S1) (the
curve shifts upw.): at the initial curve shifts upw.): at the initial
equilibrium rate E, D1 > S; equilibrium-um rate E, S1 > D;
demanders' competition makes i rise suppliers' competition makes i fall
up to equilibrium E1 (note the up to equilibrium E1 (note the
movement along the supply curve) movement along the demand curve)

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 3. Security markets and prices

◼ 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 Bond and MIB Index in 2015

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• The rate of return

Remember the formula of the RR of any security k

ykt +1 + pkt +1
rkt +1 = −1
pkt
− 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 r for bonds, a variable
dt+1 dividend for equities)

• Capital gains and losses

The formula can also be expressed as follows

ykt +1 pkt +1 − pkt
rkt +1 = +
pkt pkt
ykt +1 rate of change of the
= + pkt +1
pkt price
- capital gain > 0
yield rate - capital loss < 0
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• 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,
Vkt +1
rkt +1 = −1
pkt

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
one year

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

V determines the position of

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

lower V
pk

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%

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◼ 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: issue (supply) securities
demand for funds is decreasing in RR
RR is decreasing in the security price
security supply is increasing in its price
those who supply funds: buy securities
supply of funds is increasing in 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 amount of
security k security k
demand supply demand supply

E1

equilibrium price E
→ equilibrium RR

price price

Exercise. Draw an increase in the
demand for the security, and
determine the new equilibrium
price. How has the RR changed? Do
the security suppliers receive more
or less funds than before?
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 16
The relationship between the supply of bonds and the RR. The case of Italian State bonds

The government deficit should be

financed by borrowing (see Part
1), i.e. by selling bonds in the
market.
The higher the deficit, the higher
the RR required by lenders

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 4. The equilibrium (arbitrage) price of securities
and informational efficiency

◼ Arbitrage across securities

Can the RR of any security be set independently of (and be different from) the RR of other
equivalent securities? In an efficient market the answer is NO.

Let us use the efficiency conditions

 perfect competition
 no transaction costs
 perfect information
reformulated as follows: all operators are all freely and
equally informed about the prevailing market conditions (the
price and 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 (high price) and buy high RR (low price) assets. This is called
arbitrage.

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Consider the following process

higher RR securities demand increases price rises RR falls

lower RR securities demand decreases price 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" r

Vkt +1
rkt +1 = −1 → r
pkt

The price of each security that is established at the arbitrage equilibrium is s.t. all rk are
equal to the market rate r, i.e.
Vkt +1 Vkt +1
−1 = r  pkt =
pkt 1+ r
•The equilibrium price of a security (its "right price") is its future value discounted at the
market rate
• Informational efficiency: observing the prices, given the market rate, the market
transmits all available relevant information, i.e. the future value of each security

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 Relationship between security price and market return rate
pkt

Vkt +1
high future value pkt =
1+ r

low future value

r
Example 1. How to value a stock company.
The stock company k has a prospective profit of €20 mln. and its assets (buildings, machineries, know-
how, etc.) have a sale price of €190 mln. The future value of the company is €210 mln. The market RR
is 5%. Hence the present market value of k is pkt = €(210 mln  1.05) = €200 mln. €200 mln divided by
the number of shares gives the market price of equities k.
The market rate rises to 7%: check that pkt falls to €196 bln.
Example 2. News and prices.
Consider again Example 1.
i) News arrive that raise the prospective profits of the company to €30 mln. The future value is now
€220 mln., and hence the present market value rises to €210 mln. In fact, at the initial value of €200
mln., holding the shares of k would yield more than the market rate, rkt+1 = €(220 mln./200 mln) − 1 =
10%. Arbitrage shifts demand towards shares k and raises their price until the RR is 5% again.

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• Arbitrage at work
Consider a stock market session with the following data
− Two securities, k = 1, 2
− Constant future value V1 = 100, V2 = 150
− Market rate of return r = 10%
→ equilibrium prices: p*1 = V1/(1 + r) = 90.9, p*2 = V2/(1 + r) = 136.3
− Opening price p10 = 80, p20 = 160
→ opening RR r10 = V1/p10 – 1= 25%, r20 = V2/p20 – 1 = −6,2%

Convergence to equilibrium prices Sales (−), purchases (+)

Titolo 1 Titolo 2 Titolo 1 Titolo 2

180 20
15 security 1
160
security 2 10
140 5
136,3
120 6 0
security 1 -5
100
-10
90,9
80 -15
security 2
-20
60
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◼ Three important questions and explanations

1) Why are security prices different?

They reflect the (market information of) future value of securities; securities with
higher future value command a higher price than those with lower future value. This is
called informational efficiency

2) Why are security prices so variable ("volatile")?

They react quickly to changes in r and V. "News" about changes in V are the most
important factor. Note: V are future, unobservable variables, assessed by investors

3) If you're so smart, why aren't you so rich?

"Smart traders" present themselves as being able to make systematically higher RR than
the others. Arbitrage and informational efficiency make this impossible (at least on
average), or: "you can't beat the market". In fact, the equilibrium price formula means
that anyone in the market who buys security k at price pkt upon the information that its
future value is Vkt+1 will earn no more (no less) than the market rate r.

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◼ Fundamental valuation

Arbitrage and informational efficiency have another important implication: the truly smart
trader is the one who chooses high yield securities given all available information, not
the one who seeks to speculate (i.e. make conjectures) on unknowable future prices. This is
a.k.a the principle of fundamental valuation

Can we aim (rationally) at pure "speculative" capital gains?

Recall that the RR can be re-expressed as follows

rate of change in the price,
ykt +1 pkt +1 − pkt
rkt +1 = + or "speculative" component.
pkt pkt

yield rate of the security on the basis of all available

information at t
(rem.: all investors are freely endowed with the same
information, hence they all believe in the same
ykt+1).

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• Changes in future prices are unpredictable (rationally)

Now let us extend our view beyond one year. The investor who buys the security k in t and
holds it for a number of years up to T, can expect to obtain the compound value of its stream
of future payoffs net of changes in the price each year. Is there a rational basis to foresee
the future price?

Here is one: you know (everybody knows) the security price formula where we use a more
correct notation for the future value V
(Vkt +1|It )
pkt =
1+ r
(Vkt+1|It) reads: the t+1 value of k is computed according to all available information It,
and is the best possible forecast, as of t.
What then will pkt+1 be? By the same reasoning,
(Vkt + 2 |It +1 )
pkt +1 =
1+ r

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Hence, to foresee pkt+1 you would need foresee (Vkt+2|It+1). This is the future value of k
recomputed in t+1 if news arrive (It+1) that are unknown in t. Hence, to foresee pkt+1
as of t, you would need know now the information that will arrive in t+1. This is clearly
impossible! Indeed, if It+1 were predictable in t, it would be used immediately, and the price
would rise in t, not t+1 (see Example 2(ii) p. 21). Therefore,

in an efficient market, the only source of the RR to a security that investors can rationally
expect is its stream of future payments

As a result, the equilibrium price formula for any number of years n = 1, …, T is

ykt + n
pkt =  n
(1 + r )n
The fundamental equilibrium price of a security reflects the present value of the stream
of its future payments

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 A trading day of "Telecom Italia" at the Milan Stock Exchange.

• What determines price movements?

• Are instantaneous prices, equilibrium prices?
• Is arbitrage going on?
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