Table of continent

CHPATER ONE
INTRODUCTION..........................................................................................................................1
1.1: Definition and Nature of Financial Economics:...................................................................1
1.2: Nature and Function of Financial Intermediaries:................................................................2
1.2.1: Transaction Cost:...........................................................................................................2
1.2.2: Asymmetric Information................................................................................................3
1.3: Types of Financial Intermediaries........................................................................................5
1.4: Functions and Types of Financial Markets:..........................................................................6
1.5. Financial Instruments...........................................................................................................9
Review Questions:........................................................................................................................10
CHAPTER TWO
PORTFOLIO CHOICE.................................................................................................................11
2.1 Introduction.........................................................................................................................11
2.2 Determinants Of Asset Demand..........................................................................................12
2.3 Theory Of Portifoli Choice..................................................................................................15
2.4. Risk And Return.................................................................................................................15
2.5 Benefits Of Diversification.................................................................................................18
2.6 Systematic Risk...................................................................................................................20
2.7. Capital Assedt Pricing Model And Arbitrage Pricing Model..............................................22
QUESTIONS FOR REVIEW AND DISCUSSION......................................................................24
CHAPTER THREE
INTEREST RATES......................................................................................................................25
3.1 Introduction.........................................................................................................................25
3.2 Functions Of The Rate Of Interest In The Economy...........................................................26
3.3 The Distinction Between Interest Rates And Returns..........................................................27
3.4 Theories Of Interest Rates...................................................................................................30
3.4.1 The Classical Theory Of Interest Rates.........................................................................30
3.4.2 The Liquidity Preference Theory..................................................................................37
3.4.3 The Loanable Funds Theory.........................................................................................40
3.4.4 The Rational Expectaitons Theory................................................................................47
3.5 Term Structure Of Interest Rates.........................................................................................48
3.5.1 Expectations Hypothesis...............................................................................................49
3.5.2 Segmented Markets Theory..........................................................................................53
3.5.3 Preferred Habitat and Liquidity Premium Theories......................................................54
QUESTIONS FOR REVIEW AND DISCUSSION......................................................................59
CHAPTER FOUR
STOCK MARKETS.....................................................................................................................60
4.1. Introduction........................................................................................................................60
4.2. Debt and Equity.................................................................................................................61
4.3. Preferred versus Common Stock:.......................................................................................62
4.4. Absentee Ownership and Limited Liability:.......................................................................63
4.5. Book and market value of stocks........................................................................................64
4.6. Raising capital through Stock Markets...............................................................................65
4.7. Stock Valuation and Speculation:.......................................................................................67
4.8. Present Value Calculation...................................................................................................68
4.9. The Stock Market and Interest Rates..................................................................................70
4.10. The Tobin’s q....................................................................................................................71
4.11. The stock market and the Economy:.................................................................................73
Review Questions:........................................................................................................................75
 CHPATER ONE
INTRODUCTION
Objectives of the Chapter:

This chapter is an introduction to the course and as such it discusses what the course is all about
and other basic issues which are important to the course. Most of the topics included in this
chapter are in detail discussed in the first module for monetary economics and the purpose of
repeating them here is just to remind you about them. In general, this chapter has the following
objectives:

ü Understand the nature of financial economics

ü Review the function of financial intermediaries

ü Discuss the functions of different financial markets

1.1: Definition and Nature of Financial Economics:

Financial economics like any other branch of economics is concerned with resource allocation
over time. It is further distinguished from other branches of economics by its concentration on
monetary activities in which money and other financial assets are important for people’s
decision. It is concerned with the allocation of financial resources in an uncertain or risky
environment. Thus, it focuses on the operation of financial markets, the pricing of financial
instruments, and the financial structure of companies. It deals with the workings of financial
markets, such as the stock market and the financing of companies and includes the following
subject areas: saving, investing, borrowing, lending, insuring, hedging, diversifying, and asset
management. In summary, financial economics attempt to answer questions such as:
ü How are the prices of financial assets like stocks, bonds and currencies
determined?
ü What are the effects of a company choosing different methods of financing its
operations, such as issuing shares or borrowing?
ü What portfolio of assets should an investor hold in order to best meet his/her
 objectives?

It is clear that there is some overlap with monetary economics to the extent that both are
concerned with the study of financial markets and institutions. But, they are different in their
focus. Financial economics on the other hand deals with the micro-analysis of financial markets
and institutions while monetary economics deals with different monetary theories.

1.2: Nature and Function of Financial Intermediaries:

Financial intermediaries are financial institutions that help to transfer funds from net-savers to
net-spenders. This process of indirect finance through financial intermediaries is termed as
financial intermediation. Financial intermediaries acquire funds by issuing their own claims to
the public and then use this fund to buy other financial instruments. They include different
financial institutions like banks, insurance companies and pension funds. They play a crucial role
in the economy by transferring money from net-savers to net-spenders (borrowers) there by
increasing investment and production which in turn will improve the standard of the economy.
They make fund which would be idle in their absence available for productive investment. The
outcome will be good for the net-savers (lenders), net-spenders (borrowers) and the whole
economy. The importance of financial intermediaries rests on two factors arising from market
imperfection namely: high transaction cost and asymmetric information. They are briefly
discussed below.

1.2.1: Transaction Cost:

The time and money spend in carrying out direct financial transaction (transaction cost of direct
finance) is huge for both lenders and borrowers. The transaction cost may include different
search cost like transportation cost, time cost, and brokerage cost and contract cost like money
paid for a lawyer. These costs will be huge in the case of direct finance and hence direct finance
will be unattractive. More so, because individuals will give very small loans and hence will get
small return (interest) while the transaction cost is high. On the other hand, if an investor wants
to borrow some amount of money, he may need to approach different lenders and the total
transaction cost will be huge relative to the return he will get from the investment. As a result,
both borrowers and lenders will be reluctant to be involved in direct finance and hence will resort

2
to financial intermediaries. I.e, lenders will prefer to lend their money to financial intermediaries
and borrowers will prefer to take loan from financial intermediaries. This is so because financial
intermediaries have the expertise to minimize transaction cost. They make financial transactions
(both lending and borrowing) at a very cheap cost. They have also the advantage of economies of
scale; unlike individual agents, financial intermediaries deal with huge funds and hence the unit
transaction cost decreases. For example, while individuals may need the advice of a lawyer to
make a financial contract, a bank may have a permanently employed lawyer who will take care
of all the transactions. Banks also make big transactions and this makes them more efficient in
terms of financial transactions.

1.2.2: Asymmetric Information

The second reason for the existence of financial intermediaries is the problem of asymmetric
information which refers to the problem that one party of the market does not often know enough
about the other party to make accurate decisions. Evaluating the credit worthiness of borrower-
spenders and supervising the usage of the money afterwards requires huge cost in terms of
expertise and time which individual saver-lenders can not afford. For instance, a borrower
spender has better information about the potential returns and risk of the investment while this
information is hardly known to the saver-spender. It therefore makes sense for the individual
lenders to resort to financial intermediaries to invest (lend) their money. They are in effect
delegating the financial intermediaries to produce information about the credit-worthiness of the
borrowers. Asymmetric information creates problems in two ways: before the transaction is
made (adverse selection) and after it is made (moral hazard).

Adverse Selection:

Adverse selection in financial markets occurs when the least credit worthy borrowers who are
most likely to produce adverse (undesirable) outcome are the ones who most actively seek out a
loan and are therefore most likely to get the loan or get selected. They can for example be willing

3
to pay higher interest rate and in the absence of enough information, the lender will tend to
choose them. Because of the presence of adverse selection, lenders may decide not to make any
loan for fear the loans might be given to bad borrowers though there are also good borrowers.
This calls for financial intermediaries who can acquire information about the borrowers at a
reasonably low cost and hence will hardly make adverse selection. Among other things they can
evaluate the feasibility of the project from the proposal and study the past performance of the
borrower.

Moral Hazard:

Moral hazard is the problem created by asymmetric information after the transaction occurs.
Moral hazard in the context of financial transactions refers to the risk that the borrower might
divert the fund to some unproductive (undesirable) areas of investment viewed from the lenders
side which will make it less likely that the loan will be paid back. Normally when a loan
contract is made the borrower will promise that he will use the fund only for the specified
purpose and will pay back the money with some positive return at a specified time. But, once he
gets the fund he may divert the fund to another investment area which is risky but has higher
expected return which is therefore desirable from his point of view and undesirable from the
lenders side. This problem is a serious one for individual lenders since they hardly have the
information and the capacity to make sure that the borrower does not divert the fund to some
undesirable investment.

Because moral hazard lowers the probability that the loan will be repaid, lenders may decide not
to give loans all together to borrower-spenders. This also calls for financial intermediaries who
can easily insure that the fund is used properly once it is given to investors.

1.3: Types of Financial Intermediaries

Financial intermediaries are divided in to three broad categories: depository institutions,

contractual savings institutions, and investment intermediaries.

Depository institutions

Depository institutions are financial intermediaries that accept deposits from individuals and

4
institutions and make loans. These intuitions include commercial banks, savings and loan
associations, microfinance institutions and credit unions. They are unique from the other
intermediaries in that they are directly engaged in accepting deposit and channeling it to others.

Contractual Savings Institutions

Contractual Savings Institutions are financial intermediaries that acquire funds at periodic
intervals on a contractual basis. This group of financial intermediaries includes different
insurance companies and pension funds. Their main purpose is giving different services
(insurance and pension services). But, they are also important financial intermediaries because
they raise huge fund which they channel to investors in different ways.

Investment Intermediaries

This group of financial intermediaries includes investment banks, security brokers and mutual
funds which are involved in the purchase and sale of different securities such as bonds and
stocks. One of their functions is to help firms issue and sell securities. They advise investors
about their portfolio choice and pricing of different securities. They also serve as security
traders by arranging traders among borrowers and lenders. Besides, they acquire funds by
issuing and selling different securities and use the funds so raised to purchase diversified
portfolio of securities.

1.4: Functions and Types of Financial Markets:

Financial markets are markets where different financial assets like bonds and stocks are traded.
Examples of financial markets include: bond markets, stock markets and foreign exchange
markets. They are important means of channeling funds from those who have excess funds
(savers, lenders) to those who have a shortage (investors, borrowers). Financial markets improve
social welfare by allowing funds to move from those without productive investment
opportunities to those with such opportunities. Consumers also benefit by being allowed to make
purchases when they need them the most. Financial markets can be classified based on different
ways. Following are some classification of financial markets:

5
 i. debt versus equity markets
ii. primary versus secondary markets
iii. money versus capital markets
iv. spot versus future (option) market

Debt and Equity Markets

One way of classifying financial markets is based on the type of claim associated with the fund
transferred through the transaction in that market. Accordingly, if the transaction represents a
mere borrowing and does not give ownership title to the buyer of the security the market is
termed as debt market. A firm may for example raise fund by issuing a debt instrument, such as a
bond or a mortgage, which is a contractual agreement by the borrower to pay the holder of
instrument fixed dollar amounts at regular intervals (interest and principal payments) until a
specified date (the maturity date), when a final payment is made. The buyer of the debt
instrument will then will get his money with some return. In cases of loss or bankruptcy, he will
have first claim over the assets of the firm. I.e, if the firm that issues the instrument went
bankrupt and could not pay its debt, the holder of the instrument has the right to enforce the firm
to liquidate its assets and get his money. On the other hand, the holder of the instrument will not
have ownership title over the firm and hence his return will not depend on the profitability of the
firm.

But, if the transaction gives ownership title to the buyer of the instrument, the market is termed
as equity market. In this case, the buyer of the financial asset will be one of the owners of the
firm and unlike in the case of debt market he will not expect a predetermined return. He will
rather expect to get a series returns in terms of dividend and capital gain. Thus, unlike the buyer
of a debt instrument, his return will depend on the profitability of the firm and in case of
bankruptcy he will have a residual claim like the other owners of the firm.

Primary and Secondary Markets

Financial markets can also be classified based on the weather the financial asset traded in that
market is a new issue or an old one. A primary market is a financial market in which new issues
of a security, such as a bond or a stock, are sold to initial buyers by the corporation or
government agency borrowing the funds. A secondary market is a financial market in which

6
securities that have been previously issued (and are thus secondhand) can be resold.

When an individual buys a security in the secondary market, the person who has sold the security
receives money in exchange for the security, but the organization that issued the security acquires
no new funds. The organization acquires new funds only when its securities are first sold in the
primary market. Nonetheless secondary markets serve two important functions. First, they make
it easier to sell these financial instruments to raise cash; that is, they make the financial instru-
ments more liquid. The increased liquidity of these instruments then makes them more desirable
and thus easier for the issuing firm to sell in the primary market. Second, they determine the
price of the security that the issuing firm sells in the primary market. The firms that buy
securities in the primary market will pay the issuing corporation no more than the price that they
think the secondary market will set for this security. The higher the security's price in the
secondary market, the higher will be the price that the issuing firm will charge for a new security
in the primary market and hence the greater the amount of capital it can raise. Conditions in the
secondary market are therefore most relevant to organizations issuing securities.

Money and Capital Markets

Another way of distinguishing between markets is on the basis of the maturity of the securities
traded in each market. The money market is a financial market in which only short-term
instruments (maturity of less than one year) are traded; the capital market is the market in which
long-term debt (maturity of one year or greater) and equity Instruments are traded. Money
market securities are usually more widely traded than longer-term securities and so tend to be
more liquid.

Spot and Future (option) markets:

Financial markets can also be classified based on the timing of the contract and the transaction.
Spot markets are markets where the transaction is made at the time of lag-on the spot. For
example, if we consider a spot foreign exchange market, the exchage will be made at the time of
agreement except for some short time lag in delivery like hours or few days. While future
markets are markets where the transaction is made in a future time specified in the contract.

7
They are markets where future contracts are traded. Future contracts are contracts which are
agreements to deliver items on a specified future date at a price specified today but not paid until
delivery. To use the same example of a foreign exchange market, a buyer and a seller may agree
today to transact a foreign currency after some time say three months at rate they fix now. Future
markets are important to avoid risk arising from fluctuations in the spot market.

Option market is a market where option contracts are traded. Option contracts are contracts that
give the holder (either the buyer or the seller) the right but not the obligation to make the
transaction they set today. The holder of the right will make the transaction if the rate agreed at
the contract is favorable to him compared to the spot price at that time. Option markets also help
to avoid risk due to fluctuations in spot prices. There are two types of option contracts: call
option and put option. Call option gives the contract holder the right but not the obligation to buy
the asset at the predetermined price while put option grants the contract holder the right but not
the obligation to sell the asset.

1.5. Financial Instruments

Financial instruments are promissory notes that represent the transfer of fund from one party to
another. They are also termed as financial assets or securities. They are traded in financial
markets. When a firm wants to raise a fund it may issue a financial instrument and sell. The
buyer will pay money to the seller of the financial instrument and will in turn get the instrument
with a promise that he will get him money back with some positive return. Some financial
interments are discussed below:

Treasury Bills: are shot term debt instruments issued by governments to finance budget deficits.
They pay a predetermined amount at maturity and have not interest payment, but they effectively
pay interest by initially selling at a discount, that is, at a price lower than the set amount at the
maturity.

Stocks: are equity claims on the net income and assets of a corporation. They are issued by
corporate firms to raise fund. The buyers of stock become owners of the company.

Mortgages: are loans to households or firms to purchase housing, land or other fixed assets

8
where the asset itself serves as collateral for the loans.

Bonds: are instruments that represent loan and may be issued by firms or governments. They pay
interest unlike treasury bills.
Bank Loans: These are loans to consumers and businesses made by banks. In the case of
consumers they are given for the purchase of consumer durables like house.

Certificates of Deposit: Are certificates or books issued by banks certifying that the holder has
deposited some money in the bank. Saving deposits are good examples.

Cheques: Are papers issued by banks and given to depository who have checking accounts at
the banks. They allow the holder to make transactions by writing them.

Review Questions:
1. Discuss the difference and similarities between financial economics and monetary
economics
2. 2. Economics deals with the efficient allocation of resources. How does financial
economics help to achieve this broad goal of economics? (efficient allocation of
resources)
3. How do transaction cost and asymmetric information justify the existence of financial
intermediaries?
4. What makes financial markets from commodity markets?
5. Secondary markets do not help to raise new fund. Hence they do not have any importance
for the transfer of fund. Do you agree or disagree? Why or why not?
6. What are financial instruments?

9
 CHAPTER TWO
PORTFOLIO CHOICE
Chapter Objectives

After studying this chapter, you will be able to:

 Identify the determinants of asset demand
 Know the criteria that are important in buying different assets
 Explain the different theory of portfolio choice
 Realize the benefits of diversification

2.1 INTRODUCTION

Suppose you suddenly struck it rich. Maybe you have just won $25 million in the lottery and your
first payment of $600,000 has arrived. Or your dear departed Aunt has remembered you with a
$200,000 bequest. There are a lot of things you might want to do with this windfall: put a down
payment on a mansion, buy a Car, or invest in gold coins, land, Treasury bills, or AT & T stock.
How will you decide what portfolio of assets you should hold to store your newfound wealth?
What criteria should you use to decide among these various stores of wealth? Should you buy
only one type of asset or several different types? Dear distance learner, this chapter helps
answer these questions by developing an economic theory known as the theory of portfolio

10
choice. This theory outlines criteria that are important when deciding which assets are worth
buying. In addition, it gives us an idea why it is good to diversify and not to put all our eggs in
one basket. Accordingly, in this chapter issues like determinants of asset demand, theories of
portfolio choice, benefits of asset diversification and others will be raised and discussed
thoroughly.

The theory of portfolio choice plays a pivotal role in the study of money, banking, and financial
markets.

2.2 DETERMINANTS OF ASSET DEMAND

An asset is a piece of property that is a store of value. Items such as money, bonds, stocks, art,
land, houses, farm equipment, and manufacturing machinery are all assets. Facing the question
of whether to buy and hold an asset or whether to buy one asset rather than another, an individual
must consider the following factors:

1. Wealth, the total resources owned by the individual, including all assets
2. Expected return (the return expected over the next period) on one asset relative to
alternative assets
3. Risk (the degree of uncertainty associated with the return) on one asset relative to
alternative assets
4. Liquidity (the ease and speed with which an asset can be turned into cash) relative to
alternative assets

Wealth: When we find that our wealth has increased, we have more resources available with
which to purchase assets, and so, not surprisingly, the quantity of assets we demand increases.
But the demand for inferior assets might have the property that the quantity demanded does not
increase as wealth increases; such assets are rare, however. Hence we will always assume that
demand for an asset increases as wealth increases. The demand for different assets responds
differently to changes in wealth, however; the quantity demanded of some assets grows more
rapidly with a rise in wealth than the quantity demanded of others. The degree of this response is
measured by a concept known as the wealth elasticity of demand (which is similar to the
concept of income elasticity of demand, which you have learned in microeconomics). The wealth

11
elasticity of demand measures how much, with everything else unchanged, the quantity
demanded of an asset changes in percentage terms in response to a percentage change in wealth:

% change in quantity demanded

= Wealth elasticity of demand
% change in wealth

If, for example, the quantity of currency demanded increases only by 50 percent when wealth
increases by 100 percent, we say that currency has a wealth elasticity of demand of ½. If, for a
common stock, the quantity demanded increases by 200 percent when wealth increases by 100
percent, the wealth elasticity of demand equals 2.

Assets can be sorted into two categories, depending on the value of their wealth elasticity of
demand. An asset is a necessity if there is only so much that people want to hold, so that as
wealth grows, the percentage increase in the quantity demand of the asset is less than the
percentage increase in wealth- in other words, its wealth elasticity is less than 1. Because the
quantity demanded of a necessity does not grow proportionally with wealth, the amount of this
asset that people want to hold relative to their wealth falls as wealth grows. An asset is a luxury
if its wealth elasticity is greater than 1; and as wealth grows, the quantity demanded of this asset
grows more than proportionally, and the amount that people hold relative to their wealth grows.
Common stocks and municipal bonds are examples of luxury assets, and currency and checking
account deposits are necessities.

The effect of changes in wealth on the quantity demanded of an asset can he summarized in this
way: Holding everything else constant, an increase in wealth raises the quantity demanded of
an asset; and the increase in the quantity demanded is greater if the asset is a luxury than if it
is a necessity.

Expected returns: the return on an asset (such as a bond) measures how much we gain from
holding that asset. When we make a decision to buy an asset, we are influenced by what we
expect the return on that asset to be. If a Mobil Oil Corporation bond, for example, has a return
of 15 percent half of the time and 5 percent the other half of the time, its expected return (which
you can think of as the average return) is 10 percent. If the expected return on the Mobil Oil
bond rises relative to expected returns on alternative assets, holding everything else constant,

12
then it becomes more desirable to purchase it, and the quantity demanded increases. This can
occur in either of two ways: (1) when the expected return on the Mobil Oil bond rises while the
return on an alternative asset—say, stock in IBM—remains unchanged or (2) when the return on
the alternative asset, the IBM stock, falls while the return on the Mobil Oil bond remains
unchanged. To summarize, an increase in an asset’s expected return relative to that of an
alternative asset, holding everything else unchanged, raises the quantity demanded of the
asset.

Risk: The degree of risk or uncertainty of an asset’s returns also affects the demand for the asset.
Consider two assets, stock in Fly-by-Night Airlines and stock in Feet-on- the-Ground Bus
Company. Suppose that Fly-by-Night stock has a return of 15 percent half the time and 5 percent
the other half of the time, making its expected return 10 percent, while stock in Feet-on-the-
Ground has a fixed return of 10 percent. Fly-by-Night stock has uncertainty associated with its
returns and so has greater risk than stock in Feet-on-the-Ground, whose return is a sure thing.

A risk-averse person prefers stock in Feet-on- the-Ground (the sure thing) to Fly-by-Night stock
(the riskier asset), even though the stocks have the same expected return, 10 percent. By contrast,
a person who prefers risk is a risk preferrer or risk lover. Most people are risk-averse: Everything
else being equal, they prefer to hold the less risky asset. Hence, holding everything else
constant, if an asset’s risk rises relative to that of alternative assets, its quantity demanded will
fall.

Liquidity: Another factor that affects the demand for an asset is how quickly it can be converted
into cash without incurring large costs—its liquidity. An asset is liquid if the market in which it is
traded has depth and breadth, that is, if the market has many buyers and sellers. A house is not a
very liquid asset because it may be hard to find a buyer quickly; if a house must be sold to pay
off bills, it might have to be sold for a much lower price. And the transaction costs in selling a
house (broker’s commissions, lawyer’s fees, and so on) are substantial. A U.S. Treasury bill, by
contrast, is a highly liquid asset. It can be sold in a well-organized market where there are many
buyers, so it can be sold quickly at low cost. The more liquid an asset is relative to alternative
assets, holding everything else unchanged, more desirable it is, and the greater will be the
quantity demanded.

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2.3 THEORY OF PORTIFOLI CHOICE

All the determining factors we have just discussed can be assembled into the theory of portfolio
choice, which states that, holding all of the other factors constant:

1. The quantity demanded of an asset is usually positively related to wealth, with the
response being greater if the asset is a luxury than if it is a necessity.
2. The quantity demanded of an asset is positively related to its expected return relative to
alternative assets.
3. The quantity demanded of an asset is negatively related to the risk of its returns relative
to alternative assets
4. The quantity demanded of an asset is positively related to its liquidity relative to
alternative assets.

2.4. RISK AND RETURN

In the last section you have seen the factors that affect the demand for a financial asset. In this
section we will discuss the two most important determinants of asset demand in some detail
namely risk and return.

For a single asset with different possible return, the expected return is given by the weighted
average of the different possible returns the weights being the probabilities of the different
possible returns. For example, if we consider a bond that earns 10% interest rate half of the time
and 5% the other half of the time, the expected return will be calculated as follows:

ER = 50% (10) + 50 %( 5) = 7.5%

Therefore, the expected return of the bond is 7.5%

Similarly, the expected return of a portfolio of financial assets will be calculated using a
weighted average of the expected returns of the different assets. Here the weights are the share of
each asset from the total wealth. Thus, there are two steps to calculate the expected return of a
portfolio of assets. In the first step, we calculate the expected return of each asset using the

14
formula given above and in the second step we calculate the expected return of the portfolio
using the following formula.

Where E(Rp) is expected return of the portfolio, wi is the weight of the ith asset and E(Ri) is the
expected return of the ith asset.

For a portfolio of two assets A and B, the portfolio expeted return can be given as:

On the other hand, risk refers to the volatility of the return of the asset and is given by the
variance of the portfolio’s expected return. Variance of the portfolio can be given as:

Where:

For a two asset portfolio, the portfolio variance will be:

And for a three asset portfolio it will be:

As can be seen, as the number of assets (n) in the portfolio increases, the calculation becomes
“computationally intensive” - the number of covariance terms = n (n-1) /2. For this reason,
portfolio computations usually require specialized software.

Egnoring the other determinants of asset demand (liquidity and wealth), a retional investor will
hold a portfolio of assets with the best risk-return structure. If we consider a typical investor who
is risk averse, he will try to minimize risk and maximize return. For a given return, he will try to

15
minimize risk and for a given risk he will try to maximize expected return. If the investor is a
risk neutral he will just try to maximize expected return and does not worry about risk. I.e,
portfolios with the same expected return will be valued the same by such investor regardless of
their risk. On the other hand, if a risk lover (taker) is provided with two portfolios with the same
expected return but different in risk, he will choose the one with higher expected return or
volatiltity because he can get higher return from such a portfolio.

For the purpose of illustration, let us extend the example of the singe asset case we mentioned
earlier. Consider three bonds; A, B and C: If A gives 10% and 5% return with equal probabilty, B
given 20% 37.5% of the time and zero the rest of the time and C gives 7.5% all the time. You
should be able to see that the three bonds have the same expected return that is 7.5% but are
different in their risk. It is clear that B is the most risky asset followed by A while C is risk free
(if you want to convince yourself, you can use the above formula of variance to compare the risk
of the assets). Thus, the preferences of the the three types of agents will be as follows:

Bond A Bond B Bond C

Risk Averse 2nd 3rd 1st
Risk Nuetral - - -
Risk Lover 2nd 1st 3rd

As can be seen from the above table, the risk nuetral investor will choose Bond C because it has
the least risk (zero) and Bond B is the least prererred because it has the highest risk. A risk lover
on the other hand chooses Bond B and he ranks Bond C last because it always gives 7.5% and
there is not chance of getting a higher return. For a risk nuetral agent the three bonds are the
same and hence he is indifferent among them. This is so because he is concerned only about
expected return and risk doe not matter.

2.5 BENEFITS OF DIVERSIFICATION

Our discussion of the theory of portfolio choice indicates that most people like to avoid risk; that
is, they are risk-averse. Why, then, do many investors hold many risky assets rather than just
one? Doesn’t holding many risky assets expose the investor to more risk?

16
The old warning about not putting all your eggs in one basket holds the key to the answer:
Because holding many risky assets (called diversification), reduces the overall risk an investor
faces, diversification is beneficial. An investor can reduce portfolio risk simply by holding
instruments which are not perfectly correlated. In other words, investors can reduce their
exposure to individual asset risk by holding a diversified portfolio of assets. Diversification will
allow for the same portfolio return with reduced risk. For diversification to work the component
assets must not be perfectly correlated, i.e. correlation coefficient not equal to 1. If all assets of a
portfolio have a correlation of 0, the portfolio variance and hence volatility will be the weighted
average of the individual instruments' volatilities. If correlation is less than zero, that is, the
assets are inversely correlated, the portfolio's volatility is less than the weighted average of the
volatilities, and vice-versa.

To see why this is so, let’s look at some specific examples of how an investor fares when holding
two risky securities. Consider two assets, common stock of Frivolous Luxuries, Inc., and
common stock of Bad Times Products, Unlimited. When the economy is strong, which we’ll
assume is half of the time, Frivolous Luxuries has high sales and the return on the stock is 15
percent; when the economy is weak, the other half of the time, sales are low and the return on the
stock is 5 percent. In contrast, suppose that Bad Times Products thrives when the economy is
weak so that its stock has a return of 15 percent, but it earns less when the economy is strong and
has a return on the stock of 5 percent. Both stocks have a return of 15 percent half of the time
and 5 percent the other half of the time, and both have an expected return of 10 percent.
However, both stocks carry a fair amount of risk because there is uncertainty about their actual
returns.

Suppose now that instead of buying one stock or the other, Irving the Investor puts half his
savings in Frivolous Luxuries stock and the other half in Bad Times Products stock. When the
economy is strong, Frivolous Luxuries stock has a return of 15 percent and Bad Times Products
has a return of 5 percent. The result is that Irving earns a return of 10 percent (the average of 5
percent and 15 percent) on his holdings of the two stocks. When the economy is weak, Frivolous
Luxuries has a return of only 5 percent and Bad Times Products has a return of 15 percent, so
Irving still earns a return of 10 percent. If Irving diversifies by buying both stocks, he earns a
return of 10 percent regardless of whether the economy is strong or weak. Irving is better off

17
from this strategy of diversification because his expected return is 10 percent, the same as from
holding either Frivolous Luxuries or Bad Times Products alone, yet he is not exposed to any risk.

Although the case we have described demonstrates the benefits of diversification, it is some what
unrealistic. It is hard to find two securities with the characteristic that when the return of one is
low, the reruns of the other are always high (such a case is described by saying that the returns on
the two securities are perfectly negatively correlated). In the real world, we are more likely to
find at best returns on securities that are independent of each other; that is, when one is low, the
other is just as likely to be high as to be low.

Suppose that both securities have an expected return of 10 percent, with a realm of 5 percent half
of the time and 15 percent the other half of the time. Sometimes both securities will earn the
higher return, and sometimes both will earn the lower return. In this case, if Irving holds equal
amounts of each security, he will on average earn the same return as if he had just put all his
savings into one of the securities. However, because the returns on these two securities are
independent, it is just as likely that when one earns the high 15 percent return, the other earns the
low 5 percent return and vice versa, giving Irving a return of 10 percent (equal to the expected
return). Because Irving is more likely to earn what he expected to earn when he holds both
securities instead of just one, we can see that Irving has again reduced his risk through
diversification.

The one case in which Irving will not benefit from diversifying occurs when the returns on the
two securities move perfectly together. In this case, when the first security has a return of 15
percent, the other also has a return of 15 percent, and holding both securities result in a return of
15 percent. When the first security has a return of 5 percent, the other has a return of 5 percent,
and holding both results in a return of 5 percent. The result of diversifying by holding both
securities is a return of 15 percent half of the time and 5 percent the other half of the time, which
is exactly the same returns that are earned by holding only one of the securities. Consequently,
diversification in this case does not lead to any reduction of risk.

The examples we have just examined illustrate the following important points about
diversification:

18
 1. Diversification is almost always beneficial to the risk-averse investor because it reduces
risk except in the extremely rare case where returns on securities move perfectly together.
2. The less the returns on two securities move together, the more benefit (risk reduction)
there is from diversification.

2.6 SYSTEMATIC RISK

Given the benefits of diversification, you might think that by holding enough different securities
in a portfolio, you could eliminate risk entirely. Unfortunately, this is not possible because
securities have systematic risk, risk that can not be eliminated through diversification. In other
words, no matter how many different securities you hold in your portfolio, you will still be stuck
with some unavoidable risk, and this is the systematic risk. Systematic risk, or market risk, refers
to the risk common to all securities - except for selling short as noted below, systematic risk
cannot be diversified away (within one market). Within the market portfolio, asset specific risk
will be diversified away to the extent possible. Systematic risk is therefore equated with the risk
(standard deviation) of the market portfolio.

To understand systematic risk better, we need to recognize that we can divide the risk of an asset
into two components, systematic risk and nonsystematic risk/specific risk, the risk unique to an
asset that can be diversified away by holding enough different securities in your portfolio.
Specific risk is the risk associated with individual assets - within a portfolio these risks can be
reduced through diversification (specific risks "cancel out").

Asset risk = systematic risk + nonsystematic risk/specific risk

Nonsystematic risk is unique to an asset because it is related to the part of an asset’s return that
does not vary with returns on other assets. With many assets in a portfolio, nonsystematic risk
becomes less important because when the non-systematic part of one asset’s return goes up, it is
likely that the nonsystematic part of another asset’s return has gone down, movements that
cancel each other out. Hence with enough diversification as a result of a portfolio containing a
large number of different assets, the nonsystematic risk contributes nothing to the total risk of the
portfolio. In other words, the risk of a well-diversified portfolio is due solely to the systematic
risk of assets in the portfolio.

19
This fact is very important because it tells us that if we diversify sufficiently, the only component
of an asset’s risk that we have to worry about is its systematic risk. Systematic risk of an asset is
measured by a concept called beta, a measure of the sensitivity of an asset’s return to changes in
the value of the entire market of assets. When on average a 1 percent rise in the value of the
market portfolio leads to a 2 percent rise in the value of an asset, the beta for this asset is
calculated to be 2.0. If, conversely, the value of the asset on average rises by only 0.5 percent
when the market rises by 1 percent, the asset’s beta is 0.5.

The first asset, with a beta of 2.0, has much more systematic risk than the asset with a beta of
0.5. To see this, we first recognize that the portfolio made up of the entire market is a completely
diversified portfolio and hence has only systematic risk. When the value of the market fluctuates
by a certain amount, the asset with a beta of 2.0 fluctuates twice as much. Therefore, its return
has twice as much systematic risk. By contrast, the asset with a beta of 0.5 fluctuates less than
the market and so has less systematic risk. Because an asset with a higher beta has more
systematic risk, this asset is less desirable because the systematic risk cannot be diversified away.
Thus, holding everything else constant, an asset with a higher beta has a lower quantity
demanded. We have reached the following conclusion, which is of great importance to
participants in financial markets: the greater an asset’s beta, the greater the asset’s systematic
risk and the less desirable the asset is to hold in one’s portfolio.

2.7. CAPITAL ASSEDT PRICING MODEL AND ARBITRAGE PRICING

MODEL

Our recognition that greater systematic risk makes an asset less desirable can be used to
understand the capital asset pricing model (CAPM), a widely used theory developed by William
Sharpe, John Litner, and Jack Treynor. The CAMP is useful because it provides an explanation
for the magnitude of an asset’s risk premium, the difference between the asset’s expected return
and the risk-free interest rate (the interest rate on a security that has no possibility of default).

We have seen that an asset contributes risk to a well-diversified portfolio in the amount of its
systematic risk as measured by beta. When an asset has a high beta, meaning that it has a large
amount of systematic risk and is therefore less desirable, we would expect that investors would

20
be willing to hold this asset only if it yielded a higher expected return. This is exactly what the
CAPM tells us in the equation

Risk Premium = RETe – RETf = b (RETem – RETf)

Where RETe = expected return for the assert
RETf = risk-free interest rate
b = beta of the asset
RETem = expected return for the market portfolio

The CAPM equation provides the commonsense result that when an asset’s beta is zero, meaning
that it has no systematic risk, its risk premium will be zero. If its beta is 1.0, meaning that it has
the same systematic risk as the entire market, it will have the same risk premium as the market,
RETem,—RETf. If the asset has an even higher beta, say, 2.0, its risk premium will be greater than
that of the market. For example, if the expected return on the market is 8 percent and the risk-
free rate is 2 percent, the risk premium for the market is 6 percent. The asset with the beta of 2.0
would then be expected to have a risk premium of 12 percent (= 2 x 6 percent).

Although the capital asset pricing model has proved useful in real-world applications, it assumes
that there is only one source of systematic risk, that found in the market portfolio. However, an
alternative theory, the arbitrage pricing theory (APT), developed by Stephen Ross of Yale
University, takes the view that there are several sources of risk in the economy that cannot be
eliminated by diversification. These sources of risk can be thought of as related to economywide
factors such as inflation and changes in aggregate output. Instead of calculating a single beta,
like the CAPM, arbitrage pricing theory calculates many betas by estimating the sensitivity of an
asset’s return to changes in each factor. The arbitrage pricing theory equation is

Risk Premium = RETe – RETf

=b1(RETefactor 1 - RETf ) + b2 (RETefactor 2 - RETf ) (2)
+ … + bk (RETefactor k - RETf )

Arbitrage pricing theory thus indicates that the risk premium for an asset is related to the risk
premium for each factor and that as the asset’s sensitivity to each factor increases, its risk
premium will increase as well.

21
Which of these theories provides a better explanation of risk premiums is still uncertain. Both
agree that an asset has a higher risk premium when it has higher systematic risk, and both are
considered valuable tools for explaining risk premiums.

QUESTIONS FOR REVIEW AND DISCUSSION

1. What are the determinants of asset demand? Discuss how each is related to the demand of
a certain asset.
2. What is diversification?
3. By using an example, show how diversification is beneficial. In what circumstances do
diversification is not beneficial?
4. What is the difference between systematic risk and nonsystematic risk? Explain by using
an example.
5. Discuss the theory of portfolio choice.
6. What is wealth elasticity of demand? What are the types of assets classified based on
their wealth elasticity?
7. Discuss the impacts of change in wealth on the different types of assets.

22
 CHAPTER THREE
INTEREST RATES

Chapter Objectives

After studding this chapter, you will be able to:

 Define what interest rate is
 Realize the functions of interest rate in the economy
 Know the distinction between interest rate and returns
 Explain the different theories of the rate of interest as well as the limitations of each
theories

3.1 INTRODUCTION

The money and capital markets are one of the vast pools of funds, depleted by the borrowing
activities of households, businesses and governments and replenished by the savings these
sectors supply to the financial system. The money and capital markets make saving possible by
offering the individual saver a wide menu of choices where funds may be placed at attractive
rates of return. By committing funds to one or more financial instruments, the saver, in effect,

23
becomes a lender of funds. The financial markets also make borrowing possible by giving the
borrower a channel through which securities (I Owe You) (IOUs) can be issued to lenders. And
the money and capital markets make investment and economic growth possible by providing the
funds needed for the purchase of machinery and equipment and the construction of buildings,
highways, and other productive facilities.

Clearly, then, the acts of saving and lending, borrowing and investing are intimately linked
through the financial system. And one factor that significantly influences and ties all of them
together is the rate of interest. The rate of interest is the price a borrower must pay to secure
scarce loanable funds from a lender for an agreed-upon period. It is the price of credit. But
unlike other prices in the economy, the rate of interest is really a ratio of two quantities: the
money cost of borrowing divided by the amount of money actually borrowed, usually expressed
as an annual percentage basis.

Interest rates send price signals to borrowers, lenders, savers, and investors. For example, higher
interest rates generally bring forth a greater volume of savings and stimulate the lending of
funds. Lower rates of interest, on the other hand, tend to dampen the flow of savings and reduce
lending activity. Higher interest rates tend to reduce the volume of borrowing and capital
investment, and lower rates stimulate borrowing and investment spending. In this chapter, we
will discuss in more detail the forces that are believed by economists and financial analysts to
determine prevailing rates of interest in the financial system.

3.2 FUNCTIONS OF THE RATE OF INTEREST IN THE ECONOMY

The rate of interest performs several important roles or functions in the economy:
 It helps guarantee that current savings will flow into investment to promote economic
growth.
 It rations the available supply of credit, generally providing loanable funds to those
investment projects with the highest expected returns.
 It brings into balance the supply of money with the public’s demand for money.
 It is also an important tool of government policy through its influence on the volume of
saving and investment. If the economy is growing too slowly and unemployment is

24
 rising, the government can use its policy tools to lower interest rates in order to stimulate
borrowing and investment. On the other hand, an economy experiencing rapid inflation
has traditionally called for a government policy of higher interest rates to slow both
borrowing and spending.

To uncover these basic rate-determining forces, however, we must make a simplifying

assumption. We assume in this chapter that there is one fundamental interest rate in the economy
known as the pure or risk-free rate of interest, which is a component of all interest rates. The
closest approximation to this pure rate in the real world is the market yield on government bonds.
It is a rate of return presenting little or no risk of financial loss to the investor and representing
the opportunity cost of holding idle cash, because the investor can always invest in low-risk
bonds and earn this minimum rate of return.

3.3 THE DISTINCTION BETWEEN INTEREST RATES AND RETURNS

Many people think that the interest rate on a bond tells them all they need to know about how
well off they are as a result of owning it. If Irving the Investor thinks he is better off when he
owns a long-term bond yielding a 10 percent interest rate and the interest rate rises to 20 percent,
he will have a rude awakening: As we will shortly see, Irving has lost his shirt! How well a
person does by holding a bond or any other security over a particular time period is accurately
measured by the return or, in more precise terminology, the rate of return. For any security, the
rate of return is defined as the payments to the owner plus the change in its value, expressed as a
fraction of its purchase price. To make this definition clearer, let us see what the return would
look like for a $ 1000 face-value coupon bond with a coupon rate of 10 percent that is bought for
$1000, held for one year, and then sold for $1200. The payment to the owner are the yearly
coupon payments of $100, and the change in its value is $1200-$1000 = $200. Adding these
together and expressing them as a fraction of the purchase price of $1000 gives us the one-year
holding-period return for this bond:

$100 + $200 $300

= = 0.30 = 30%
$1000 $1000

25
You may have noticed something quite surprising about the return that we have just calculated: It
equals 30 percent. This demonstrates that the return on a bond will not necessarily equal the
interest rate on that bond. We now see that the distinction between interest rate and return can
be important, although for many securities the two may be closely related.
More generally, the return on a bond held from time‘t’ to time‘t+1’ can be written as

C + P1+1 − pt
RET=
Pt (1)

Where RET = return from holding the bond from time t to time t +1
Pt = price of the bond at time t
Pt +1 = Price of the bond at time t+1
C = coupon payment
A convenient way to rewrite the return formula in Equation 1 is to recognize that it can be split
up into two separate terms. The first is the current yield i c (the coupon payment over the purchase
price):
C
=i
Pt c
The second term is the rate of capital gain, or the change in the bond’s price relative to the
initial purchase price:

Pt +1−Pt
=g
Pt
Where g = rate of capital gain. Equation 1 can then be rewritten as

RET = ic +g (2)

which shows that the return on a bond is the current yield i c plus the rate of capital gain. This
rewritten formula illustrates the point we just discovered. Even for a bond for which the current
yield ic is an accurate measure of the yield to maturity, the return can differ substantially from the
interest rate. Returns will differ from the interest rate especially if there are sizable fluctuations
in the price of the bond that produce substantial capital gains or losses.

26
To explore this point even further, let’s look at what happens to the returns on bonds of different
maturities when interest rates rise. Table 3.1 calculates the one-year return on several 10 percent
–coupon-rate bonds all purchased at par when interest rates on all these bonds rise from 10 to 20
percent. Several key findings in this table are generally true of all bonds.

 The only bond whose return equals the initial yield to maturity is one whose time to
maturity is the same as the holding period (see the last bond in Table 3.1).
 A rise in interest rates is associated with a fall in bond prices, resulting in capital losses
on bonds whose terms to maturity are longer than the holding period.
 The more distant a bonds maturity, the greater the size of the price change associated with
an interest-rate change.
 The more distant a bond’s maturity, the lower the rate of return that occurs as a result of
the increase in the interest rate.
 Even though a bond has a substantial initial interest rate, its return can turn out to be
negative if interest rates rise.

TABLE 3.1: One-Year Returns on Different-Maturity 10 percent Coupon Rate Bonds

When Interest Rates Rise
(1) (2) (3) (4) (5) (6) (7) (8)
Years to Initial Initial Yield to Price Initial Rate of Rate of
Maturity Yield to price Maturity Next Current Capital Return
When Maturity ($) Next Year Yield Gain (6+7)
Bonds is (%) year (%) ($) (%) (%) (%)
Purchased
30 10 1000 20 503 10 -49.7 -39.7
20 10 1000 20 516 10 -48.4 -38.4
10 10 1000 20 597 10 -40.3 -30.3
5 10 1000 20 741 10 -25.9 -15.9
2 10 1000 20 917 10 -8.3 +1.7
1 10 1000 20 1000 10 0.0 +10.0

At first it frequently puzzles students that a rise in interest rates can mean that a bond has been a
poor investment (as it puzzles poor lrving the Investor). The trick to understanding this is to
recognize that a rise in the interest rate means that the price of a bond has fallen. A rise in interest
rates therefore means that a capital loss has occurred, and if this loss is large enough, the bond

27
can be a poor investment indeed. For example, we see in Table 3.1 that the bond that has 30
years to maturity when purchased has a capital loss of 49.7 percent when the interest rate rises
from 10 in 20 percent. This loss is so large that it exceeds the current yield of 10 percent,
resulting in a negative return (loss) of —39.7 percent.

3.4 THEORIES OF INTEREST RATES

3.4.1 THE CLASSICAL THEORY OF INTEREST RATES

One of the oldest theories concerning the determinants of the pure or risk-free interest rate is the
classical theory of interest rates, developed during the 18th and 19th centuries by a number of
British economists and elaborated by Irving Fisher (1930) earlier in this century. The classical
theory argues that the rate of interest is determined by two forces: (1) the supply of savings,
derived mainly from households, and (2) the demand for investment capital, coming mainly from
the business sector. Let us examine these rate-determining forces of savings and investment
demand in detail.

Saving by Households

What is the relationship between the rate of interest and the volume of savings in the economy?
Most saving in modern industrialized economies is carried out by individuals and families. For
these households, saving is simply abstinence from consumption spending. Current saving,
therefore, are equal to the difference between current income and current consumption
expenditures.

In making the decision on the timing and amount of saving to be done, households typically
consider several factors: the size of current and long-term income, the desired savings target, and
the desired proportion of income to be set aside in the form of savings (i.e., the propensity to
save). Generally, the volume of household savings rises with income. Higher-income families
and individuals tend to save more and consume less relative to their total income than families
with lower incomes.

28
Although income levels probably dominate saving decisions, interest rates also play an important
role. Interest rates affect an individual’s choice between current consumption and saving for
future consumption. The classical theory of interest assumes that individuals have a definite time
preference for current over future consumption. A rational individual, it is assumed, will always
prefer current enjoyment of goods and services over future enjoyment. Therefore, the only way
to encourage an individual or family to consume less now and save more is to offer a higher rate
of interest on current savings. If more were saved in the current period at a higher rate of returns,
future consumption and future enjoyment would be increased. For example, if the current rate of
interest is 10 percent and a household saves $100 instead of spending it on current consumption,
it will be able to consume $110 in goods and services a year from now.

The classical theory considers the payment of interest a reward for waiting - the postponement of
current consumption in favor of greater future consumption. Higher interest rates increase the
attractiveness of saving relative to consumption spending, encouraging more individuals to
substitute current saving (and future consumption) for some quantity of current consumption.
This so-called substitution effect calls for a positive relationship between interest rates and the
volume of savings. Higher interest rates bring forth a greater current volume of savings.

Saving by business firms

Not only households, but also businesses, save and direct a portion of their savings in to the
financial markets to purchase securities and make loans. Most businesses hold savings balances
in the form of retained earnings (as reflected in their equity or net worth accounts). In fact, the
increase in retained earnings reported by businesses each year is a key measure of the volume of
current business saving. And these retained earnings supply most of the money for annual
investment spending by business firms.

Although the principal determinant of business saving is profits, interest rates also play a role in
the decision of what proportion of current operating costs and long-term investment expenditures
should be financed internally and what proportion externally. Higher interest rates in the money
and capital markets typically encourage firms to use internally generated funds more heavily in

29
financing projects. Conversely, lower interest rates encourage greater use of external funds from
the money and capital markets.

Saving by Government

Governments also save, though less frequently than households and businesses. In fact, most
government saving (i.e. a budget surplus) appears to be unintended saving that arises when
government receipts unexpectedly exceed the actual amount of expenditures. Income flows in
the economy (out of which government tax revenues arise) and the pacing of government
spending programs are the dominant factors affecting government savings. Interest rates are
probably not a key factor here.

The Demand for Investment Funds

Business, household, and government savings are important determinants of interest rates
according to the classical theory of interest, but not the only ones. The other critical rate
determining factor is investment spending by business firms.

The investment decision-Making process: The process of investment decision making by

business firms is complex and depends on a host of qualitative and quantitative factors. The firm
must compare its current level of production with the capacity of its existing facilities and decide
whether it has sufficient capacity to handle anticipated demand for its product. If expected future
demand will strain the firm’s existing facilities, it will consider expanding its operating capacity
through net investment.

Most business firms have several investment projects under consideration at any one time.
Although the investment decision-making process varies from firm to firm, each business
generally makes some estimate of net cash flows (i.e., revenues minus all expenses including
taxes) that each project will generate over its useful life. From this information plus knowledge

30
of each investment project’s acquisition cost, management can calculate its expected rate of
return and compare that expected return with anticipated returns from alternative projects.

One of the more popular methods for performing this calculation is the internal rate of return
method, which equates the total cost of an investment project with the future net cash flows
(NCF) expected from that project discounted back to their present values. Thus,
NCF 1 NCF 2 NCF n
Cost of project = + +. ..+ ( 1)
( 1+r )1 (1+ r )2 (1+r )n
where each NCF represents the expected annual net cash flow from the project and r is its
expected internal rate of return. The internal rate performs two functions: (1) it measures the
annual yield the firm expects from an investment project and (2) it reduces the value of all future
cash flows expected over the economic life of the project down to their present value to the firm.
In general, if the firm must choose among several mutually exclusive projects, it will choose the
one with the highest expected internal rate of return.

Although the internal rate of return provides a yardstick for selecting potentially profitable
investment projects, how does a business executive decide how much to spend on investment at
any point in time? How many projects should be chosen? It is here that the financial markets
play a key role in the investment decision- making process.

Suppose a business firm is considering the following projects with their associated expected
internal rates of return:

Project Expected internal rate of return

(annualized)
A 15%
B 12
C 10
D 9
E 8

How many of these projects will be adopted? The firm must compare each project’s expected
internal return with the cost of raising capital- the interest rate- in the money and capital markets
to finance the project.

31
Assume that funds must be borrowed in the financial marketplace to complete any of the above
projects and the current cost of borrowing – the rate of interest – is 10 percent. Which projects
are acceptable from an economic standpoint? As shown in Exhibit 3.1, projects A and B clearly
are acceptable because their expected returns exceed the current cost of borrowing capital (10
percent) to finance them. The firm would be indifferent about project C because its expected
return is no more than the cost of borrowed funds (i.e., the current interest rate). Projects D and
E, on the other hand, are unprofitable at this time.

It is through changes in the cost of raising funds that the financial markets can exert a powerful
influence on the investment decisions of business firms. As credit becomes scarcer and more
expensive, the cost of borrowed capital rises, eliminating some investment projects form
consideration. For example, if the cost of borrowed funds rises from 10 to 13 percent, it is
obvious that only project A in our earlier example would then be economically viable. On the
other hand, if credit becomes more abundant and less costly, the cost of capital for the individual
firm will tend to decline and more projects will become profitable. In our example, a decline in
the cost of borrowed funds forms 10 to 8 ½ percent would make all but project E economically
viable and probably acceptable to the firm.

Exhibit 3.1 The Cost of Capital and the Investment Decision

Cost of capital A
(Percent per 15%
annum) B
12%
C Cost of Capital funds = 10%
10%
D
9%
E
8%
0
Dollar cost of investment projects

Investment Demand and the Rate of Interest: This reasoning explains, in part, why the
demand for investment capital by business firms was regarded by the classical economists as

32
 negatively related to the rate of interest. Exhibit 3.2 depicts the business investment demand
schedule as drawn in the classical theory. This demand schedule slopes downward and to the
right. At low rates of interest, more investment projects become economically viable and firms
require more funds to finance a longer list of projects. On the other hand, if the rate of interest
rises to high levels, fewer investment projects will be pursued and fewer funds will be required
from the financial markets. For example, at a 12 percent rate of interest, only $150 billion in
funds for investment spending might be demanded by business firms in the economy. If the rate
of interest drops to 10 percent, however, the volume of desired investment by firms might rise to
$200 billion.

Exhibit 3.2 The Investment Demand Schedule in the Classical Theory of

Interest Rates

Rate of interest
(percent per annum)
I
12

10

150 200
Volume of investment spending ($billions)

The Equilibrium Rate of Interest in the Classical Theory of Interest

The classical economists believed that interest rates in the financial markets were determined by
the interplay of the supply of saving and the demand for investment. Specifically, the equilibrium
rate of interest is determined at the point where the quantity of savings supplied to the market is
exactly equal to the quantity of funds demanded for investment. As shown in Exhibit 3.4, this
occurs at point E, where the equilibrium rate of interest is i E and the equilibrium quantity of
capital funds traded in the financial markets is QE.

To illustrate, suppose the total volume of savings supplied by businesses, households, and
governments in the economy at an interest rate of 10 percent is $200 billion. Moreover, at this

33
 same 10 percent rate, businesses would also demand $200 billion in funds for investment
purposes. Then 10 percent must be the equilibrium rate of interest, and $200 billion is the
equilibrium quantity of funds that would be traded in the money and capital markets.

Exhibit 3.3 The Equilibrium Rate of Interest in the Classical Theory

Rate of interest Demand for Inv’t
(Percent per
annum) Volume of saving

iE E

QE
Volume of saving and investment

Limitations of the Classical Theory of Interest

The classical theory sheds considerable light on the factors affecting interest rates. How- ever, it
has serious limitations. The central problem is that the theory ignores factors other than saving
and investment that affect interest rates. For example, many financial institutions have the power
to create money today by making loans to the public. When borrowers repay their loans, money
is destroyed. The volume of money created or destroyed affects the total amount of credit
available in the financial system and therefore must be considered in any explanation of the
factors determining interest rates.

In addition, the classical theory assumes that interest rates are the principal determinant of the
quantity of savings available. Today economists recognize that income is more important in
determining the volume of saving. Finally, the classical theory contends that the demand for
borrowed funds comes principally from the business sector. Today, however, both consumers and
governments are important borrowers, significantly affecting credit availability and cost.

3.4.2 THE LIQUIDITY PREFERENCE THEORY

34
The classical theory of interest has been called a long-term explanation of interest rates because
it focuses on the public’s thrift habits and the productivity of capital - factors that tend to change
slowly. During the 1930s, British economist John Maynard Keynes (1936) developed a short-
term theory of the rate of interest that, he argued, was more relevant for policymakers and for
explaining near-term changes in interest rates. This theory is known as the liquidity preference
theory of interest rates.

The Demand for Liquidity

Keynes argued that the rate of interest is really a payment for the use of a scarce resource, money.
Businesses and individuals prefer to hold money for carrying out daily transactions and also as a
precaution against future cash needs even through its yield is low or nonexistent. Investors in
fixed-income securities, such as corporate and government bonds, frequently desire to hold
money as a haven against declining security prices. Interest rates, therefore, are the price that
must be paid to induce money holders to surrender a perfectly liquid asset and hold other assets
that carry more risk. At times the preference for liquidity grows very strong. Unless the
government expands the money supply, interest rates will rise. In the theory of liquidity
preference, only two outlets for investor funds are considered: bonds and money (including bank
deposits). Money provides perfect liquidity (instant spending power); bonds pay interest but
cannot be spent until converted into cash.

If interest rates rise, the market value of bonds paying a fixed rate of interest falls; the investor
would suffer a capital loss if those bonds were converted into cash. On the other hand, a fall in
interest rates results in higher bond prices; the bondholder will experience a capital gain if his or
her bonds are sold for cash. To the classical theorists, it was irrational to hold money because it
provided little or no return. To Keynes, however, the holding of money could be a perfectly
rational act if interest rates were expected to rise, because rising rates can result in substantial
losses for investors in bonds.

Total Demand for Money: The total demand for money in the economy is simply the sum of
transactions, precautionary, and speculative demands. Because the principal determinant of
transaction and precautionary demand is income, not interest rates, these money demands are

35
fixed at a certain level of national income. Let this demand be represented by the quantity OK
shown along the horizontal axis in Exhibit 3.4. Then, any amount of money demanded in excess
of OK represents speculative demand. The total demand for money is represented along curve
DT. Therefore, if the rate of interest lies at the moment at i, Exhibit 3.4 shows that the speculative
demand for money will be KJ and the total demand for money will be OJ.

The Supply of Money

The other major element determining interest rates in liquidity preference theory is the supply of
money. In modern economies, the money supply is controlled, or at least closely regulated, by
government. Because government decisions concerning the size of the money supply presumably
are guided by the public welfare, not by the level of interest rates, we assume that the supply of
money is inelastic with respect to the rate of interest. Such a money supply curve is represented
in Exhibit 3.5 by the vertical line Ms.

Exhibit 3.4 The total demand for money in the economy

36
 DT

AD

Total demand
for many
DT

0
K J
Quantity of money demanded ($ billions)

Exhibit 3.5 The equilibrium interest in the liquidity preference theory

Rate of interest DT MS
(percent per Supply of Money
annum)

iE Total demand
for Money

0
Quantity of money demanded and supplied ($ billons)

The Equilibrium Rate of Interest in Liquidity Preference Theory

The interplay of the total demand for and the supply of money determine the equilibrium rate of
interest in the short run. As shown in Exhibit 3.5, the equilibrium rate is found at point i E, where
the quantity of money demanded by the public equals the quantity of money supplied. Above this
equilibrium rate, the supply of money exceeds the quantity demanded, and some businesses,
households, and units of government will try to dispose of their unwanted money balances by
purchasing bonds. The prices of bonds will rise, driving interest rates down toward equilibrium
at iE. On the other hand, at rates below equilibrium, the quantity of money demanded exceeds the

37
supply. Some decision makers in the economy will sell their bonds to raise additional cash,
driving bond prices down and interest rates up toward equilibrium.

Limitations of the Liquidity preference Theory

Like the classical theory of interest, liquidity preference theory has limitations. It is a short term
approach to interest rate determination unless modified because it assumes that income remains
stable. In the longer term, interest rates are affected by changes in the level of income and
inflationary expectations. Indeed, it is impossible to have a stable equilibrium interest rate
without also reaching an equilibrium level of income, saving, and investment in the economy.
Also, liquidity preference considers only the supply and demand for the stock of money, whereas
business, consumer, and government demands for credit clearly have an impact on the cost of
credit. A more comprehensive view of interest rates is needed that considers the important roles
played by all actors in the financial system: businesses, households, and governments.

3.4.3 THE LOANABLE FUNDS THEORY

A view that overcomes many of the limitations of earlier theories is the loanable funds theory
of interest rates. This view argues that the risk-free interest rate is determined by the interplay
of two forces: the demand for and supply of credit (loanable funds). The demand for loanable
funds consists of credit demands from domestic businesses, consumers, and governments and
also borrowing in the domestic market by foreigners. The supply of loanable funds stems from
four sources: domestic savings, hoarding demand for money, money creation by the banking
system, and lending in the domestic market by foreign individuals and institutions. We consider
each of these demand and supply factors in turn.

Consumer Demand for Loanable Funds

38
Domestic consumers demand loanable funds to purchase a wide variety of goods and services on
credit. Recent research indicates that consumers are not particularly responsive to the rate of
interest when they seek credit but focus instead principally on the nonprice terms of a loan, such
as the down payment, maturity, and size of installment payments. This implies that consumer
demand for credit is relatively inelastic with respect to the rate of interest. Certainly a rise in
interest rates leads to some reduction in the quantity of consumer demand for loanable funds
(particularly when home mortgage credit is involved), whereas a decline in interest rates
stimulates some additional consumer borrowing. However, along the consumer’s relatively
inelastic demand schedule, a substantial change in the rate of interest must occur before the
quantity of consumer demand for funds changes significantly.

Domestic Business Demand for Loanable Funds

The credit demands of domestic businesses generally are more responsive to changes in the rate
of interest than is consumer borrowing. Most business credit is for such investment purposes as
the purchase of inventories and new plant and equipment. As noted earlier in our discussion of
the classical theory of interest, a high interest rate eliminates some business investment projects
form consideration because their expected rate of return is lower than the cost of funds. On the
other hand, at lower rates of interest, many investment projects look profitable, with their
expected returns exceeding the cost of funds. Therefore the quantity of loanable funds demanded
by the business sector increases as the rate of interest falls.

Government Demand for Loanable Funds

Government demand for loanable funds is a growing factor in the financial markets but does not
depend significantly on the level of interest rates. This is especially true of borrowing by the
federal government. Federal decisions on spending and borrowing are made by congress in
response to social needs and the public welfare, not the rate of interest. More over, the federal
government has the power both to tax and to create money to pay its debts. State and local
government demand, on the other hand, is slightly interest elastic because many local
governments are limited in their borrowing activities by legal interest rate ceilings. When open

39
market rates rise above these legal ceilings, some state and local governments are prevented form
offering their securities to the public.

Foreign Demand for Loanable Funds

In recent years, foreign banks and corporations, as well as foreign governments, have
increasingly entered the huge financial marketplace to borrow billions of dollars. This huge
foreign credit demand is sensitive to the spread between domestic lending rates and interest rates
in foreign markets. If Ethiopia’s interest rates decline relative to foreign rates, foreign borrowers
will be inclined to borrow more in Ethiopia and less abroad. At the same time, with higher
foreign interest rates, Ethiopia’s lending institutions will increase their foreign lending and
reduce the availability of loanable funds to domestic borrowers. The net result, then, is a negative
or inverse relationship between foreign borrowing and domestic interest rates relative to foreign
interest rates.

Total Demand for Loanable Funds

The total demand for loanable funds is the sum of domestic consumer, business, and government
credit demands plus foreign credit demands. This demand curve slopes downward and to the
right with respect to the rate of interest, as shown in Exhibit 3.6. Higher rates of interest lead
some businesses, consumers, and governments to curtail their borrowing plans; lower rates bring
forth more credit demand. However, the demand for loanable funds does not determine the rate
of interest by itself. The supply of loanable funds must be added to complete the picture.

The Supply of Loanable Funds

Loanable funds flow into the money and capital markets from at leas four different sources: (1)
domestic saving by businesses, consumers, and governments; (2) dishoarding (spending down)
of excess money balances held by the public; (3) creation of money by the domestic banking
system; and (4) lending to domestic borrowers by foreigners. We consider each of these sources
of funds in turn.

Exhibit 3.6 Total Demand for Loanable Funds

40
Rate of interest
(Percent per annum) DLF (= D consumer + D business + D government + D foreign)

DLF

0
Total demand for loanable funds
($ billions)

Domestic Saving: The supply of domestic savings is the principal source of loanable funds. As
noted earlier, most saving is done by households and is simply the difference between current
income and current consumption. Businesses, however, also save, by retaining a portion of
current earnings and by adding to their depreciation reserves. Government saving, while
relatively rare, occurs when current revenues exceed current expenditures.

The net effect of the income, substitution, and wealth effects leads to a relatively interest-
inelastic supply of savings curve. Substantial changes in interest rates usually are required to
bring about significant changes in the volume of aggregate saving in the economy.

Dishoarding of Money Balances: Still another source of loanable funds is centered on the
public’s demand for money relative to the available supply of money. As noted earlier, the
public’s demand for money (cash balances) varies with interest rates and income levels. The
supply of money, on the other hand, is closely controlled by the government. Clearly the two-
money demand and money supply- need not be the same. The difference between the public’s
total demand for money and the money supply is known as hoarding. When the public’s demand
for cash balances exceeds the supply, positive hoarding of money takes place as some individuals
and businesses attempt to increase their cash balances at the expense of others. Hoarding reduces
the volume of loanable funds available in the financial markets. On the other hand, when the
public’s demand for money is less than the supply available, negative hoarding (dishoarding)
occurs. Some individuals and businesses will dispose of their excess cash holdings, increasing
the supply of loanable funds available in the financial system.

41
Creation of Credit by the Domestic Banking System: Commercial banks and nonbank thrift
institutions offering payments accounts have the unique ability to create credit by lending and
investing their excess reserves. Credit created by the domestic banking system represents an
additional source of loanable funds, which must be added to the amount of savings and the
dishoarding of money balances (or minus the amount of hoarding demand) to derive the total
supply of loanable funds in the economy.

Foreign Lending to the Domestic Funds Market: Finally, foreign lenders also provide large
amounts of credit to domestic borrowers. These inflowing loanable funds are particularly
sensitive to the difference between a nation’s interest rates, say Ethiopia, and interest rates
overseas. If domestic rates rise relative to interest rates offered aboard, the supply of foreign
funds to domestic markets will tend to rise. Foreign lenders will find it more attractive to make
loans to domestic borrowers. At the same time, domestic borrowers will turn more to foreign
markets for loanable funds as domestic interest rates climb relative to foreign rates. The
combined result is to make the net foreign supply of loanable funds to the domestic credit market
positively related to the spread between domestic and foreign rates of interest.

Total Supply of Loanable Funds

The total supply of loanable funds, including domestic saving, foreign lending, dishoarding of
money, and new credit created by the domestic banking system, is depicted in Exhibit 3.7. The
curve rises with higher rates of interest, indicating that a grater supply of loanable funds will
flow into the money and capital markets when the returns form lending increase.

Exhibit 3.7 The supply of loanable funds

Rate of interest
(percent per annum)
SLF (=Domestic saving
+
Newly Created money
+
Foreign lending to
domestic credit markets
–
Hoarding demand)

42
 SLF
0
Volume of loanable funds supplied

The Equilibrium Rate of Interest in the Loanable Funds Theory

The two forces of supply and demand for loanable funds determine not only the volume of
lending and borrowing going on in the economy but also the rate of interest. The interest rate
tends toward the equilibrium point at which the supply of loanable funds equals the demand for
loanable funds. This point of equilibrium is shown in Exhibit 3.8 at iE.

If the interest rate is temporarily above equilibrium, the quantity of loanable funds supplied by
domestic savers and foreign lenders, by the banking system, and from the dishoarding of money
(or minus hoarding demand) exceeds the total demand for loanable funds, and the rate of interest
will be bid down. On the other hand, if the interest rate is temporarily below equilibrium,
loanable funds demand will exceed the supply. The interest rate will be bid up by borrowers until
it settles at equilibrium once again.

Exhibit 3.8 The Equilibrium Rate of Interest in the Loanable Funds Theory

Rate of interest DLF

(percent per annum)

Equilibrium rate of SLF

interest
iE

43
 0
QE
Volume of loanable funds

The equilibrium depicted in Exhibit 3.8 is only a partial equilibrium position, however. This is
due to the fact that interest rates are affected by conditions in both the domestic and world
economies. For the economy to be in equilibrium, planned saving must equal planned investment
across the whole economic system. For example, if planned investment exceeds planned saving
at the equilibrium rate shown in Exhibit 3.8, investment spending occurs, incomes will rise,
generating a greater volume of savings. Eventually, interest rates will fall. Similarly, if exchange
rates between dollars, birr, and other world currencies are not in equilibrium with each other,
there will be further opportunities for profit available to foreign and domestic lenders by moving
loanable funds form one country to another.

Only when the economy, the money market, the loanable funds market, and foreign currency
markets are simultaneously in equilibrium will interest rates remain stable. Thus, a stable
equilibrium interest rate will be characterized by the following:
1. Planned saving = Planned investment (including business, household, and government
investment) across the whole economic system (i.e. equilibrium in the economy).
2. Money supply = Money demand (i.e. equilibrium in the money market).
3. Quantity of loanable funds supplied = Quantity of loanable funds demanded (i.e.
equilibrium in the loanable funds market).
4. The difference between foreign demand for loanable funds and the volume of loanable
funds supplied by foreigners to the domestic economy = the difference between current
exports from and imports into the domestic economy (i.e., equilibrium in the balance of
payment and foreign currency markets).

3.4.4 THE RATIONAL EXPECTAITONS THEORY

In recent years, a fourth major theory about the forces determining interest rates has appeared
and now appears to be gaining supporters. This is the rational expectations theory of interest

44
rates. It builds on a growing body of research evidence that the money and capital markets are
highly efficient institutions in digesting new information affecting interest rates and security
prices.

For example, when new information appears about investment, saving, or the money supply,
investors begin immediately to translate that new information into decisions to borrow or lend
funds. In a short space of time – perhaps in minutes or seconds- security prices and interest rates
change to reflect the new information. So rapid is this process of the market digesting new
information that security prices and interest rates presumably impound the new data from
virtually the moment they appear. In a perfectly efficient market, it is impossible to win excess
returns consistently by trading on publicly available information.

The important assumptions and conclusions of the rational expectations theory are that (1) the
prices of securities and interest rates should reflect all available information and the market uses
all of this information to establish a probability distribution of expected future prices and interest
rates; (2) changes in rates and security prices are correlated only with unanticipated, not
anticipated, information; (3) the correlation between rates of return in successive time periods is
zero; (4) no unexploited opportunities for profit (above a normal return) can be found in the
‘securities’ markets; (5) transactions and storage costs for securities are negligible and
information costs are small relative to the value of securities traded; and (6) expectations
concerning future security prices and interest rates are formed rationally and efficiently.

3.5 TERM STRUCTURE OF INTEREST RATES

One factor that influences the interest rate on a bond is its term to maturity: Bonds with identical
risk, liquidity, and tax characteristics may have different interest rates because the time
remaining to maturity is different. A plot of the yields on bonds with differing terms to maturity
but the same risk, liquidity, and tax considerations is called a yield curve, and it describes the
term structure of interest rates for particular types of bonds, such as government bonds. Yield
curves can be classified as upward-sloping, flat, and down-ward-sloping (the last sort is often
referred to as a n inverted yield curve). When yield curves slope upward, the long-term interest
rates are above the sort-term interest rates; when yield curves are flat, short- and long- term
interest rates are the same; and when yield curves are inverted, long-term interest rates are below

45
short-term interest rates. Yield curves can also have more complicated shapes in which they first
slope up and then down, or vice versa.

Besides explaining why yield curves take on different shapes at different times, a good theory of
the term structure of interest rates must explain the following three important empirical facts.
1. Interest rates on bonds of different maturities move together over time.
2. When short-term interest rates are low, yield curves are more likely to have an
upward slope; when short-term interest rates are high, yield curves are more likely to
slope downward and be inverted.
3. Yield curves almost always slope upward

Three theories have been put forward to explain the term structure of interest rates, that is, the
relationship among interest rages on bonds of different maturities reflected in yield curve
patterns: (1) the expectations hypothesis, (2) the segmented markets theory, and (3) the preferred
habitat theory.

3.5.1 Expectations Hypothesis

The expectations hypothesis of the term structure states the following commonsense proposition:
The interest rate on a long-term bond will equal an average of short-term interest rates that
people expect to occur over the life of the long-term bond. For example, if people expect that
short-term interest rates will be 10 percent on average over the coming five years, the
expectations hypothesis predicts that the interest rate on bonds with five years to maturity will be
10 percent too. If short-term interest rates were expected to rise even higher after this five-year
period so that the average short-term interest rate over the coming 20 years is 11 percent, then
the interest rate on 20-year bonds would equal 11 percent and would be higher than the interest
rate on five-year bonds. We can see that the explanation provided by the expectations hypothesis
for why interest rates on bonds of different maturities differ is that short-term interest rates are
expected to have different values at future dates.

The key assumption behind this theory is that buyers of bonds do not prefer bonds of one
maturity over another, so they will not hold any quantity of a bond if its expected return is less

46
than that of another bond with a different maturity. Bonds that have this characteristic are said to
be perfect substitutes. What this means in practice is that if bonds with different maturities are
perfect substitutes, the expected return on these bonds must be equal.

To see how the assumption that bonds with different maturities are perfect substitutes leads to the
expectations hypothesis, let us consider the following two investment strategies:
1. Purchase a one-year bond, and when it matures in one year, purchase another one-year
bond.
2. Purchase a two-year bond and hold it until maturity.

Because both strategies must have the same expected return if people are holding one-and two-
year bonds, the interest rate on the two-year bond must equal the average of the two one-year
interest rates. For example, let’s say that the current interest rate on one-year bond is 9 percent
and you expect the interest rate on the one-year bond next year to be 11 percent. If you pursue
the first strategy of buying the two one-year bonds, the expected return over the two years will
average out to be (9% + 11%)/2 = 10% per year. You will be willing to hold both the one-and
two-year bonds only if the expected return per year of the two-year bond equals this. Therefore,
the interest rate on the two-year bond must equal 10 percent, the average interest on the two one-
year bonds.

We can make this argument more general. For an investment of $1, consider the choice of
holding, for two periods, a two-period bond or two one-period bonds. Using the definitions
i t = today ' s (time t ) int erest rate on a one− period bond
e
i t+1 = int erest rate on a one− period bond exp ected for next period (time t−1 )
i 2t = today ' s (time t ) int erest rate on the two− period bond

the expected return over the two periods from investing $1 in the two-period bond and holding it
for the two periods can be calculated as

2
( 1+i2t ) ( 1 + i2t ) − 1= 1+2 i2t + ( i2 t ) −1
After the second period, the $1 investment is worth (1 + i2t) (1+i2t). Subtracting the $1 initial
investment form this amount and dividing by the initial $1 investment gives the rate of return

47
calculated in the above equation. Because (i2t)2 is extremely small – if i2t = 10%=0.10, then (i2t)2 =
0.01-we can simplify the expected return for holding the two-period bond for the two periods to
2i2t

With the other strategy, in which one-period b154onds are bought, the expected return on the $1
investment over the two periods is

(1+it) (1+iet+1) – 1

After the first period, the $1 investment becomes 1+it and this is reinvested in the one-period
bond for the next period, yielding an amount (1 + i t) (1 + iet+1). Subtracting the $1initial
investment from this amount and dividing by the initial investment of $1 gives the expected
return for the strategy of holding one-period bonds for the two periods. Because i t (ie t+1 ) is also
extremely small – if it = iet+1= 0.10, then it (iet+1) = 0.01- we can simplify this to
it + iet+1

Both bonds will be held only if these expected returns are equal, that is, when
2i2t = it + iet+1

Solving for i2t in terms of the one-period rates, we have

e
i +i t +1
i 2t = t
2 (1)
which tells us that the two-period rate must equal the average of the two one-period rates. We can
conduct the same steps for bonds with a longer maturity so that we can examine the whole term
structure of interest rates. Doing so, we will find that the interest rate of i nt on an n-period bond
must equal

e e e
t +1 t+2 t +(n−1)
it + i +i +. . . +i
i nt =
n (2)

Equation 2 states that the n-period interest rate equals the average of the one-period interest rates
expected to occur over the n-period life of the bond. This is a restatement of the expectations
hypothesis in more precise terms.

48
A simple numerical example might clarify what the expectations theory in equation 2 is saying.
If the one-year interest rate over the next five years is expected to be 5,6,7,8, and 9 percent,
equation 2 indicates that the interest rate on the two-year bond would be

5 %+6 %
=5 .5 %
2
While for the five-year bond it would be

5 %+6 %+7 %+8 %+9 %

=7 %
5
Doing a similar calculation for the one-, three-, and four-year interest rates, you should be able to
verify that the one- to five-year interest rates are 5.0, 5.5, 6.0, 6.5, and 7.0 percent, respectively.
Thus we see that the rising trend in expected short-term interest rates produces an upward-
sloping yield curve along which interest rates rise as maturity lengthens.

The expectations hypothesis is an elegant theory that provides an explanation of why the term
structure of interest rates (as represented by yield curves) changes at different times. When the
yield curve is upward-sloping, the expectations hypothesis suggests that short-term interest rates
are expected to rise in the future, as we have seen in our numerical example. In this situation, in
which the long-term rate is currently above the short-term rate, the average of future short-term
rates is expected to be higher than the current short-term rate, which can occur only if short term
interest rates are expected to rise. This is what we see in our numerical example. When the yield
curve slopes downward and is inverted, the average of future short-term interest rates is expected
to be below the current short-term rate, implying that short-term interest rates are expected to
fall, on average, in the future. Only when the yield curve is flat does the expectations hypothesis
suggest that short-term interest rates are not expected to change, on average, in the future.

The expectations hypothesis also explains fact 1 that interest rates on bonds with different
maturities move together over time. Historically, short-term interest rates have had the
characteristic that if they increase today, they will tend to be higher in the future. Hence a rise in
short-term rates will raise people’s expectations of future short-term rates. Because long-term
rates are the average of expected future short-term rates, a rise in short –terms rates will also
raise long-term rates, causing short-and long-term rates to move together.

49
The expectations hypothesis also explains fact 2 that yield curves tend to have an upward slope
when short-term interest rates are low and are inverted when short-term rates are high. When
short-term rates are low, people generally expect them to rise to some normal level in the future,
and the average of future expected short-term rates is high relative to the current short-term rate.
Therefore, long-term interest rates will be substantially above current short-term rates, and the
yield curve would then have an upward slope. Conversely, if short-term rates are high, people
usually expect them to come back down. Long-term rates would then drop below short-term
rates because the average of expected future short-term rates would be below current short-term
rates and the yield curve would slope downward and become inverted.

The expectations hypothesis is an attractive theory because it provides a simple explanation of

the behavior of the term structure, but unfortunately it has a major shortcoming: it can not
explain fact 3 that yield curves usually slope upward. The typical upward slope of yield curves
implies that short-term interest rates are usually expected to rise in the future. In practice, short-
term interest rates are just as likely to fall as they are to rise, and so the expectations hypothesis
suggests that the typical yield curve should be flat rather than upward-sloping.

3.5.2 Segmented Markets Theory

As the name suggests, the segmented markets theory of the term structure sees markets for
different-maturity bonds as completely separate and segmented. The interest rate for each bond
with a different maturity is then determined by the supply of and demand for that bond with no
effects form expected returns on other bonds with other maturities.

The key assumption in the segmented markets theory is that bonds of different maturities are not
substitutes at all, so the expected return from holding a bond of one maturity has no effect on the
demand for a bond of another maturity. This theory of the term structure is at the opposite
extreme to the expectations hypothesis, which assumes that bonds of different maturities are
perfect substitutes.

The argument for why bonds of different maturities are not substitutes is that investors have
strong preferences for bonds of one maturity but not for another, so they will be concerned with

50
the expected returns only for bonds of the maturity they prefer. This might occur because they
have a particular holding period in mind, and if they match the maturity of the bond to the
desired holding period, they can obtain a certain return with no risk at all. For example, people
who have a short holding period would prefer to hold short-term bonds. Conversely, if you were
putting funds a way for your young child to go to college, your desired holding period might be
much longer, and you would want to hold longer-term bonds.

In the segmented markets theory, differing yield curve patterns are accounted for by supply and
demand differences associated with bonds of different maturities. If, as seems sensible, investors
have short desired holding periods and generally prefer bonds with shorter maturities that have
less interest-rate risk, the segmented markets theory can explain fact3 that yield curves typically
slope upward. Because the demand for long-term bonds is relatively lower than that for short-
term bonds in the typical situation, long-term bonds will have lower prices and higher interest
rates, and hence the yield curve will typically slope upward.

Although the segmented markets theory can explain why yield curves usually tend to slope
upward, it has a major flaw in that it cannot explain facts 1 and 2. Because it views the market
for bonds of different maturities as completely segmented, there is no reason for a rise in interest
rates on a bond of one maturity to affect the interest rate on a bond of another maturity.
Therefore, it cannot explain why interest rates on bonds of different maturities tend to move
together (fact 1). Second, because it is not clear how demand and supply for short- versus long-
term bonds changes with the level of short-term interest rates, the theory cannot explain why
yield curves tend to slope upward when short-term interest rates are low and to be inverted when
short-term interest rates are high (fact 2).
Because each of our two theories explains empirical facts that the other cannot, a logical step is
to combine the theories, which leads us to the preferred habitat theory and closely related
liquidity premium theory.

3.5.3 Preferred Habitat and Liquidity Premium Theories

51
The preferred habitat theory of term structure states that the interest rate on a long-term bond will
equal an average of short-term interest rates expected to occur over the life of the long-term bond
plus a term (liquidity) premium that responds to supply and demand conditions for that bond.

The preferred habitat theory’s key assumption is that bonds of different maturities are substitutes,
which means that the expected return on one bond does influence the expected return on a bond
of a different maturity, but it allows investors to prefer one bond maturity over another. In other
words, bonds of different maturities are assumed to be substitutes but not perfect substitutes. We
might think of investors as having a preference for bonds of one maturity over another, a
particular bond maturity where they are most comfortable to stay; we might then say that they
have a preferred habitat. Investors still care about the expected returns on bonds with a maturity
other than their preferred maturity, and so they will not allow expected returns on one bond to get
too far out of line with that on another bond with a maturity other than their preferred maturity,
and so they will not allow expected returns on one bond to get too far out of line with that on
another bond with a different maturity. Because they prefer bonds of one maturity over another,
they will be willing to buy bonds that do not have the preferred maturity only if they earn a
somewhat higher expected return. If investors prefer the habitat of short-term bonds over longer-
term bonds, for example, they might be willing to hold short-term bonds even though they have a
lower expected return. This means that investors would have to be paid a positive term premium
to be willing to hold a long-term bond. Such an outcome would modify the expectations
hypothesis by adding a positive term premium to the equation that describes the relationship
between long-and short-term interest rates. The preferred habitat theory is thus written as

e e e
t +1 t +2 t + (n−1)
i t +i +i +. .. .+i
i nt = + K nt (3 )
n

Where Knt = the term premium for the n-period bond at time t.
Closely related to the preferred habitat theory is the liquidity premium theory, which takes a
somewhat more direct approach to modifying the expectations hypothesis. It reasons that a
positive term (liquidity) premium must be offered to buyers of longer-term bonds to compensate
them for their increased interest-rate risk. This reasoning leads to the same Equation 3 implied by

52
the preferred habitat theory, with the proviso that the term premium K nt is always positive and
rises with the term to maturity of the bond.

A simple numerical example similar to the one we used for the expectations hypothesis further
clarifies what the preferred habitat and liquidity premium theories in Equation 3 are saying.
Again suppose that the one-year interest rate over the next five years is expected to be 5,6,7,8,
and 9 percent, while investors’ preferences for holding short-term bonds mean that the term
premiums for one – to five-year bonds are 0, 0.25, 0.5, 0.75, and 1.0 percent, respectively.
Equation 3 then indicates that the interest rate on the two-year bond would be

5 %+6 %
+0. 25 %=5 .75 %
2
While for the five-year bond it would be

5 %+6 % +7 %+8 %+9 %

+1 %=8 %
5
Doing a similar calculation for the one-, three-, and four-year interest rates, you should be able to
verify that the one- to five- year interest rates are 5.0, 5.75, 6.5, 7.25, and 8.0 percent,
respectively. Comparing these findings with those for the expectations hypothesis, we see that
the preferred habitat and liquidity premium theories produce yield curves that slope more steeply
upward because of investors’ preferences for short-term bonds.

Let’s see if the preferred habitat and liquidity premium theories are consistent with all three
empirical facts we have discussed. They explain fact 1 that interest rates on different- maturity
bonds move together overtime: a rise in short-term interest rates indicates that short-term interest
rates will, on average, be higher in the future, and the first term in Equation 3 then implies that
long-term interest rates will rise along with them.

They also explain why yield curves tend to have an especially steep upward slope when short-
term interest rates are low and to be inverted when short-term rates are high (fact 2). Because
investors generally expect short-term interest rates to rise to some normal level when they are
low, the average of future expected short-term rates will be high relative to the current short-term
rates, and the yield curve would then have a steep upward slope. Conversely, if short-term rates

53
are high, people usually expect them to come back down. Long-term rates would then drop
below short-term rates because the average of expected future short-term rates would be so far
below current short-term rates that despite positive term premiums, the yield curve would slope
downward.

The preferred habitat and liquidity premium theories explain fact 3 that yield curves typically
slope upward by recognizing that the term premium rises with a bond’s maturity because of
investors’ preferences for short-term bonds. Even if short-term interest rates are expected to stay
the same on average in the future, long-term interest rates will be above short-term interest rates,
and yield curves will typically slope upward.

How can the preferred habitat and liquidity premium theories explain the occasional appearance
of inverted yield curves if the term premium is positive? It must be that at times short-term
interest rates are expected to fall so much in the future that the average of the expected short-
term rates is well below the current short-term rate. Even when the positive term premium is
added to this average, the resulting long-term rate will still be below the current short-term
interest rate.

As our discussion indicates, a particularly attractive feature of the preferred habitat and liquidity
premium theories is that they tell you what the market is predicting about future short-term
interest rates just by looking at the slope of the yield curve. A steeply rising yield curve, as in
panel (a) of Exhibit 3.9, indicates that short-term interest rates are expected to rise in the future.
A moderately steep yield curve, as in panel (b), indicates the short-term interest rates are not
expected to rise or fall much in the future. A flat yield curve, as in panel (c), indicates that short-
term rates are expected to fall moderately in the future. Finally, an inverted yield curve, as in
panel (d), indicates that short-term interest rates are expected to fall sharply in the future.

54
 E
xhibit 3.9 Yield Curves and the Market’s Expectations of Future Short-Term interest Rates

55
QUESTIONS FOR REVIEW AND DISCUSSION

1. What is interest rate?

2. Explain the functions of the rate of interest in the economy.
3. What is the difference between the classical theory of interest rates and that of the theory
of interest rate developed by John Maynard Keynes?
4. In the classical theory of the rate of interest, how is investment decision made.
5. According to the loanable funds theory of interest rates, the risk free interest rate is
determined by the interplay of two forces: the demand for and supply of credit (loanable
funds). Discuss.
6. The liquidity preference theory of the interest rates is considered as a short run theory of
the rate of interest. Why?
7. Discuss the rational expectations theory of interest rates.
8. What is the term structure of interest rates?
9. List the empirical facts that a good theory of the term structure of interest rates should
explain.
10. What is/are the major source of discrepancy between the expectations hypothesis and the
segmented markets theories of the term structure of interest rates?
11. The preferred habitat theory of term structure of interest rates is considered as the
combination of the other two theories: the expectations hypothesis and the segmented
market theories. Why?

56
 CHAPTER FOUR
STOCK MARKETS

Objectives of the Chapter:

This chapter will help you understand the overall nature and importance of one important
financial market called stock market. Specifically you will be able to understand the following
points after you finish this chapter.

 How stock markets help to raise capital for corporate firms

 The difference between common and preferred stocks

 The difference between raising fund through loan and issuance of stock

 What makes corporate firms different from the not corporate ones

 The difference between book value and present value of a stock

 How the present (market) value of stocks is calculated

 The importance of speculation in pricing of stocks

 The effect of interest rate on the price of stocks

 The link between the stock market and the economy

4.1. Introduction

As you know from your discussion on types of financial markets in the first chapter of this
Module, while stocks are financial assets that represent ownership of corporate firms, stock
markets are financial markets where these financial assets are traded. The owners of a
corporation’s stock are the legal owners of the firm. Although they do not normally make
production, pricing, and personnel decisions, share-holders elect a board of directors that hires
the top executives and supervises their management of the firm. That is why they are called
absentee owners. Their liability is also limited in the sense that if their firm is totally bankrupt its

57
debt will not be transferred to their personal property and what they loose will be just what they
have invested in the firm through their stocks. Since they are owners of the firms, the return for
their capital will be in the form of dividend and capital gain.

The legal concept of a corporation and hence stock in the modem sense began in England in the
early stages of the industrial revolution with the intention of dividing ownership among many
investors and protecting them if the firm is mismanaged. Most investors are “outside”
shareholders in the sense that they have nothing to do with the day-to-day operations of the
company, leaving that to the firm’s management.

Stock markets are very important in raising fund either for new or existing firms. Most big firms
are corporate firms that raise their capital by issuing and selling their stocks. In general, they
have strong impact over the economy. If there are well developed stock markets it will be easy
for firms to raise fund and investment will be facilitated. The economy will stop to depend on
few capitalists and there will be big number of small investors who will together raise huge
financial capital. But, the economy also affects the market. The more active and growing the
economy is the more conducive will be for these markets to flourish.

Even though, there are two types of stocks namely common stock and preferred stock the chapter
will focus on the former. A brief distinction of the two types of stocks is however provided.

4.2. Debt and Equity

Financial assets such as bonds are legally binding agreements to pay specified amount of money
(principal plus interest). i.e., they are legal debts and do not represent any claim on the asset of
the borrower (the firm). Stocks (shares), on the other hand, represent equity or claim over the
firm issuing (and selling) the stocks. A corporate firm may raise fund by issuing and selling
bonds and/or stocks. When it sells bonds, the bond holders hold legally binding promissory notes
and if the firm does not earn enough money to pay its debts, it will be forced to go bankrupt and
liquidate its assets and pay its debt. The stock holders in such a case will lose part or the whole of
their investment on the firm.

58
On the contrary, if the firm sells stocks, the buyers of the stock become legal owners of the firm.
They have a residual claim on the firm after its debts have been paid. In case of bankruptcy, the
firm will be liquidated and the money will first be used to pay the firm’s debt and if there is any
thing remaining it will go to the stock holders. On the other hand, if the firm becomes successful
and earns huge profit, the bond holders will get only their principal and a fixed return (interest)
while the stock holders, as owners of the firm share the profit in the form of dividend and rise in
the value of their stock. Their return in the form of dividends and capital gains depends on the
profitability of the firm while the return for the owners of bonds (borrowers) is pre-determined
and does not depend on the profitability of the firm. In general terms, if the firm grows and
prospers, the bondholders receive only the fixed income they have been promised, nothing more,
whereas the stockholders, as owners of the firm, share the benefits of growth and prosperity. The
firm’s directors, acting on behalf of the shareholders, decide how much of these profits to
distribute as dividends and how much to retain for buying more plaits and equipment to expand
the firm.

4.3. Preferred versus Common Stock:

There are two types of stocks viz., common stock and preferred stock. The key distinction
between the two types of stocks rests on the priority given to each in the distribution of earnings.
Preferred stockholders are entitled to a fixed dividend that they receive (though it may change
over time) before common stockholders may receive dividends. Thus, preferred stock shares the
characteristics of both common stock and a debt. Like the holder of common stock, the preferred
stockholder is entitled to dividends which will be paid only when the firm makes a positive
profit. Thus, the chance of getting return on their capital invested depends on the presence of
profit which in turn depends on the performance of the firm. Unlike in the case of common
stock, however, the dividends are a specified percentage of par or face value of the stock. This
makes preferred stock similar to debt (bond) because like loans or bonds they are entitled to a
fixed rate of return. But, failure to pay dividend to preferred stock holders does not force the firm
in to bankruptcy. In other words, if the firm does not make profit does not have enough money to
be given to the holders of preferred stocks it will not be forced to sell its assets.

59
4.4. Absentee Ownership and Limited Liability:

True it is, stock holders are legal owners of the firm. They are, however, absentee owners in the
sense that they do not have anything to do with the day to day routine activities of the firm. They
are not involved in the production, pricing, personnel and other decisions of the firm. They leave
this to the management body which is hired and supervised by the board of directors who in turn
are elected by the whole group of stock holders.

Though stock holders are the owners of a corporation, they have limited liability unlike owners
in the case of sole proprietor ship and partnership. This is to say that, they are not personally
responsible for the firm’s debt and their maximum loss in the case of total bankruptcy is the
money they invested in the firm-their stock value. If a corporation cannot pay its debts, then its
bankruptcy leaves the shareholders with worthless stock certificates — a disappointing outcome,
but still better than having to come up with additional money to satisfy the firm’s creditors.
Presumably, this limited liability encourages people to invest in stock, becoming part owners of
large businesses. This being the advantage of owning a corporate firm vis-à-vis a sole
proprietorship and partnership, double taxation is its disadvantage. i.e. the firm’s profit will be
taxed like any other profit and that part of the profit which will be distributed to the stock holders
in the form of dividends will be also subject to personal income tax. Suppose that a company
earns Br. 10 a share and wants to distribute this to the owners. If the company is not a
corporation, each owner receives Br. 10 and pays perhaps a 20 percent personal income tax,
keeping Br. 8. If the business is a corporation, though, then it must pay say another 25 percent
corporate income tax, leaving Br. 7.5 to be distributed as dividends, on which shareholders then
pay a 20 percent tax — leaving each only 80%(7.5) which equals Br. 6 The double taxation
amounts to an effective 40 percent tax rate.

4.5. Book and market value of stocks

At any point in time, the balance of the value of all assets of the firm that remains after all debts
have been paid represents the book-value of all outstanding stocks and the book value of a stock
will be calculated by dividing the total book value of the firm by the number of stocks. It is based
on the firm’s balance sheet that the book value of the firm is calculated and it does not need to be
equal the market value of the firm. This is so because the book value of the assets is estimated

60
based on their historical prices (though depreciation will be deducted for some assets) while the
market value of the firm and hence the market value of its stock depends on current factors like
profitability of the the firm. The market value of the stock may also increase if the firm is
believed to be more profitable in the future by the general public.

An extremely condensed balance sheet of a hypothetical firm is shown in the following table.
This firm has Br. 100 million in assets mostly plant, equipment, and other real assets. Because it
has Br. 40 million in debts outstanding, shareholders’ equity (what would be left if the firm were
liquidated and the debts repaid) comes to Br. 60 million. If there are 5 thousand shares
outstanding, this works out to Br. 12000 a share. This estimate of the firm’s value per share is
called the book value of the firm’s stock, because it is derived from the firm’s books — the
accountants’ balance sheets.

Balance sheet of a Hypothetical Firm (values in

millions)
Assets Liabilities and Capital
Real 90 Debt 40
Financial 10 Equity 60
100 100

As is mentioned above, the market price of a firm’s stock may be above or below the book value,
because investors don’t value a firm in the same way that accountants do. Assets are generally
carried on the accountants’ books at original cost and, in the case of buildings and equipment,
depreciated over time to indicate wear and tear. However, if land prices and construction costs
increase, the replacement cost of a firm’s real assets may be far larger than their original cost, let
alone their depreciated cost. If so, the firm’s stock may be worth far more than its book value,
here Br. 12000 a share. On the other hand, a firm may have very expensive assets that are not
profitable, and investors won’t pay Br. 12000 a share for a company that won’t make money and
can’t afford to pay dividends.

4.6. Raising capital through Stock Markets

61
Firms that are in need of fund for expansion purpose may raise capital either by borrowing
(selling bonds) or by selling stocks as discussed earlier. In the former case only asset and liability
of the firm will increase while capital remains constant. Such a fund may not be enough and
appropriate for long run expansion plans of the firm. A firm which is not incorporated currently
(sole proprietorship or partnership) may transform itself in to a corporate firm and raise
additional capital. It will do so by issuing stocks with total value of the current capital plus the
amount of expansion and selling some of the stocks to new owners while the rest will be owned
by the current owner/s. If the firm is already incorporated and wants to raise additional capital it
will issue and sell stocks with the total value of the amount of capital to be raised. The new
issues may be sold to existing share holders or new ones. A new firm may also start as a
corporation by issuing and selling its new issues of shares to those interested to be owners of the
firm.

Incorporation also helps to transform the value of some illiquid assets of firms in to liquid form.
A firm may own some illiquid asset (illiquid asset refers to an asset like good will which is
important to the firm but can not be changed in to cash easily) arising from a rise in price of
some of its fixed assets such as building and due to some good will attached to it by the public
say because of its expected high profit potential. As a result the market value of the firm will be
higher than its present (book) value. In both cases it is not possible to transform the benefit in to
liquid form. In the first case the owners of the firm can only enjoy the benefit by selling the asset
whose value has increased while in the second case they have to wait for the years to come to
reap the benefit of high profit potential. But, with incorporation the firm does not have to sell its
fixed asset and wait to get higher profit. If the firm is already incorporated it will take in to
consideration the value of its illiquid asset when it issues new stocks for the purpose of
expansion. i.e., when it expands its capital it will issue new stock with total value of the amount
of expansion and the illiquid asset. The money equivalent to the value of the illiquid asset will be
distributed to the current share holders. From individual share holders’ point of view, higher
price of assets and profit potential leads to a rise in the demand (and hence price) for their stock.
As a result, the stock holders can sell their stock in a secondary market and enjoy the benefit of
higher price or maintain their stock in which case the market value of their stock will rise.

62
A currently unincorporated firm with high value of assets and high potential of profitability, may
on the other hand, become a corporate one by issuing and selling stocks. In doing so, the owner
(owners) will issue stocks with total value equivalent to the market value of the firm (its book
value plus the imputed value for its profitability). When transforming in to a corporate firm, the
firm may expand by issuing stocks with total value of the firm’s market value plus the amount of
expansion. For example, suppose we have a firm owned by two partners with a market value of
Birr 300,000.00 and the owners have decided to expand their firm by a value of Biff 500,000.00
while the benefit in terms of higher profit after expansion is imputed to be Birr 100,000.00, and
the value of its assets rise by 100,000.00. They will issue stocks with total value of one million
birr and possess stocks with value of half million birr and the new stock holders will together
own the other half stocks with a total value of half million. The rise in the incumbents’ wealth by
Birr 200,000.00 arises from the illiquid asset of the firm in the form of rise in the value of its
assets and higher profit potential. In the absence of incorporation they can not enjoy this high
potential of profitability on the spot and at best they can enjoy only in the form of future higher
profits if they can make the expansion by borrowing, say by issuing bonds. In reality, they may
not be able to get the amount of loan they need for their plan of expansion.

4.7. Stock Valuation and Speculation:

The intrinsic value of a stock is its present value of its prospective cash flow, discounted by the
stock holder’s required return (opportunity cost) which is a function of the returns expected from
alternative investments (securities), its relative risk, and other relevant considerations like
liquidity. For true investors who purchase stocks for the sake of investment and not for the sake
of re-sale, the return of a stock is the cash flow in the form of stream of dividends. Like any
security (financial asset), a stock has an expected value based on which investors will make
decision.

In contrast to investors who are willing to hold stock as an asset that will bring long-run cash
flows in the form of dividend and capital gains, speculators buy stocks not for the long-run cash
flow, but to sell a short while later for a profit. What matters for them is not the prosperity of the
firm, it is rather what the stocks will be sold at after some time, say after a year. For speculators,
a stock is worth what others will pay for it in the future and the game is to guess what others will

63
pay tomorrow for what you buy today. Profitability of the firm, therefore, affects the value of the
stock viewed by the eyes of speculators only indirectly by affecting what the public will be
willing to pay for the stock. Speculators, therefore, buy stocks in order to get quick profits by
selling the stocks at higher prices.

They may, as a result, lead to stock price to depart from its intrinsic value. For example, if they
think that the price of a particular stock will rise the price of the stock will tend to rise is termed
as self fulfilling prophecy and is common in many economic activities where speculation is
involved.

It is not sensible to pay Br. 25 for an investment of which you believe the prospective (cash flow)
to justify a value of 30, if you also believe that the market will value it at 20 three months hence.
I.e, even if you expect the return for a given investment like purchase of a stock to be high, if
you at the same time expect its price to fall after a month or two, you will not buy it as a
speculator. You will not also buy it as a real investor because you could buy it at a lower price
after a short period of time.

Those who believe in fundamental analysis consider such guessing games like the Greater Fool
Theory: you buy shares at an inflated price, hoping to find an even bigger fool who will buy
these shares from you at a still higher price.

In a well developed stock markets many of those who buy and sell stock are speculators, hoping
for quick profits, and this behaviour of speculators can cause price to depart from intrinsic
values. Speculators are like the wind that blows a boat about its anchor — present value.
Fundamental analysis can be used to provide a rational explanation of stock prices.

4.8. Present Value Calculation

To calculate the present value of a stock for a particular individual who may be considering
buying the stock will depend on the stream of dividends expected and his required rate of return.
If D is the dividend t periods from now and R is the shareholder’s required return, then the
present value of this cash flow is

64
 D1 D2 D3
P= + + +.. . .. (1 )
( 1+ R ) ( 1+ R )2 ( 1+ R )3

P may also be treated as market value or price of the stock while D may be interpreted in a
broader sense like ‘anticipated growth rate of earnings, dividends, and stock price’

A special case is the constant-dividend-growth model, in which the dividend grows at a steady
rate say g each period: D2 = (1 + g) D1. If g < R, then the present value given by Equation 1
simplifies to
D1
P=
R−g ……………………………… (2)

Equation 2 gives the present value of a stock whose dividends grow at a constant rate g.
Dividends never grow at an absolutely constant rate. The appeal of Equation 2 is that it is a
reasonable and manageable approximation that has some very logical implications.

Notice, particularly, how important the growth rate is to the value of stock. At a 10 percent
required return, a stock paying a Br. 5 dividend is worth P = 5/(0. 10 — 0.00) = Br. 50 if no
growth is expected, and worth twice as much if the dividend is expected to grow by 5 percent a
year: P = 5/(0. 10 — 0.05) = Br. 100. The present values for other growth rates are shown in the
following table.

Growth makes a big difference because of the power of compounding. The difference between 0
percent and 5 percent growth may not sound like much

Table 10.4 present value of a Br. 5 Dividend,

R = 10 percent
Growth Rate g Present Value P
0% Br. 50.00
2% 62.50
4% 83.33
6% 125.00
8% 250.00

65
(and it really isn’t for the first few years), but 50 years down the road, the first company will still
be paying a Br. 5 dividend while the second pays Br. 5(1.0550) =Br. 57.34.

The present value of a preferred stock is also calculated using similar formula except that now
the dividend is constant. In other words, preferred stock dividends represent an annuity that does
not end, or perpetuity. The value of perpetuity of level dividends, each in the amount of D is the
amount of the D divided by the required rate of return R.

D
P = R ………………………. (3)

For example, if D is 5 and R is 0.06 P will be 83.3

4.9. The Stock Market and Interest Rates

When investors’ required rate of return increases, there are decline in the present value of any
given cash flow. For a given dividend stream, a high rate of return requires a low price, whereas
a low required rate of return necessitates a high price.

Because so much of their cash flow is in the distant future, stocks, especially growth stocks, are
similar to very-long-term bonds in that they have long durations and substantial capital risk. To
illustrate the effect of required return on present value, consider again the example of a stock
with a current Br. 5 dividend and a variety of possible growth rates, this time comparing 11
percent with 10 percent required returns, as in the following table. Notice, first, that stock prices
are very sensitive to required returns and, second, that this is especially true of growth stocks.
Because a large part of their present value consists of distant dividends, stocks are long-term
assets with substantial capital risk.

The Effect of the Required Return on a

Stock’s present Value
Growth Present value Percentage
Change
Rate g R=10% R=11%
0% 50.00 45.45 -9.1%
2% 62.50 55.55 -11.1%

66
 4% 83.33 71.43 -14.3%
6% 125.00 100.00 -20.0%
8% 250.00 166.67 -33.3%

It is often thought, wrongly, that the only reason high interest rates depress the stock market is
that higher interest rates may mean increased costs for businesses or a weaker economy and
depressed sales. Even if costs are constant and the economy stable, higher interest rates depress
stock prices for the same reason they depress bond prices. Assets are, to varying degrees,
substitutes in investors’ eyes, and the required rates of return that investors use to discount the
cash flow from assets depend on the yields available on alternative investments. When the
returns available on government bonds rise, so do the required returns on corporate bonds and
stocks, pushing these asset prices downward. Otherwise, investors would forsake corporate
stocks and bonds for the higher available on government bonds.

To the extent that financial markets are competitive and efficient, these ripples are felt almost
immediately. Because of the dissatisfaction that would otherwise occur, prices fall across a broad
spectrum of assets virtually simultaneously. Stock-market analysts pay close attention to other
financial markets and to news of government financial policies.

The fact that low interest rates increase both bond and stock prices (and higher interest rates
reduce both) does not mean that bond and stock prices always move in the same direction.
Although bonds have a fixed cash flow (except in defaults), stocks have a variable cash flow
with dividends that go up and down with the economy. Because the economy and interest rate
rates can move in the same or opposite directions, sometimes bond and stock price move
together and, at other times, they diverge.

If the economic outlook is unchanged while interest rates fluctuate, stock and bond prices will
move together. If the economic outlook changes, then the relative movements of bond and stock
prices depend on whether the economy and interest rates move in the same or opposite
directions. When interest rates rise, bad economic news reinforces the drop in stock prices but
good economic news cushions the drop, perhaps even propelling stock prices upward at the same

67
time that bond prices are falling. When interest rates decline, good economic news reinforces
rising stock prices, whereas a weak economy restrains stock prices.

4.10. The Tobin’s q

A strong economy encourages businesses to expand and increases stock prices. Low interest rates
also encourage business expansion and raise stock prices. James Tobin, a famous economist
argues that the net effect of the current state of the economy and of interest rates on business
investment can be gauged by the level of stock prices, specifically by the value of Tobin’s q
which is the ratio of the value placed on a firm by financial markets to the replacement cost of its
assets:

Market value of firm

q= (2)
Re placement cos t of firm ' s assets

The logic behind Tobin’s q can be illustrated by a simple example: Suppose that a corporate firm
in the hotel industry is planning to build a new restaurant with Br. 1 million and is expected to
earn a constant Br. 200,000 annual profit (a 20 percent return on its cost), which will be paid out
each year to the chain’s shareholders. The value that financial markets place on this restaurant
depends not on the one million Birr cost of construction, but on the value of its 200,000 Birr
annual cash flow.

If government bonds yield 5 percent, then perhaps stock in a risky restaurant is priced to yield 10
percent. If so, then Equation 2 with a zero growth rate gives a market value of

200 , 000 200 , 000

P= = =2 , 000 , 000
0 .10−0 . 00 0 .10

Valued at 2 million, the 200,000 cash flow gives shareholders their requisite 10 percent return.
The market value of this restaurant is twice its cost of construction

Market value of firm 2, 000 , 000

q= = =2
Re placement cost of firms assets 1, 000 , 000

68
The value of Tobin’s q is larger than 1 because the restaurant’s 20 percent profit rate is larger
than the shareholders’ 10 percent required return.

If, on the other hand, Treasury bonds pay 20 percent and restaurant share-holders price their
stock to give a 25 percent return, then the value of a 200,000 annual cash flow is only 800,000.

200 , 000 200 , 000

P= = =800 ,000
0 .25−0 . 00 0 .25

Because the restaurant’s 20 percent profit rate is less than shareholders’ 25 percent required
return, the value of Tobin’s q is less than 1:

Market value of firm 800 ,000

q= = =0. 8
Re placement cost of firm ' s assets 1 ,000 , 000

The link between Tobin’s q and investment is provided by the observation that business
expansion benefits shareholders only if the rate of return that the firm can earn on its investments
is larger than shareholders’ required rate of return as when the restaurant can earn a 20 percent
return and the share holders require only 10 percent. This is one of the primary ways in which
financial markets affect real economic activity. When interest rates are low, so are shareholders’
required returns, making it more likely that prospective investments are sufficiently profitable to
justify making them on behalf of share holders. If as in the second case, shareholders require a
25 percent return, construction of the restaurant does not benefit shareholders; they would be
better off if the firm paid out the $1 million as a dividend and let shareholders investment it
themselves.

Equivalently, the firm can ask whether, if it were to sell shares in its new restaurant venture, it
could raise enough money to cover the cost of constructing the restaurant. It can if the value of
Tobin’s q is larger than 1, but not otherwise. Thus Tobin’s q provides a barometer of the financial
incentives for business expansion, and we will use it for this purpose in later chapters.

4.11. The stock market and the Economy:

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Like any other financial market, the stock market is also strongly correlated with the state of the
economy and the affect goes both directions. In other words, the performance of the stock market
affects the economy positively and the vise versa. The more developed and efficient the stock
market becomes the larger and faster the stock transactions will be. This in turn, will, increase
the number of corporate firms. The volume of funds to be raised by issuing and selling stocks
will also increase. As a result, investment, production and employment will be boosted. On top
of that, the income and hence the consumption expenditure of stock holders will increase which
will also increase production and investment by creating additional demand for goods and
services.

In general, there does seem to be a striking correlation between the stock market and the
economy. Why? Three possible explanations are consistent with fundamental analysis: the stock
market may influence the economy, the economy may influence the stock market, or some third
factor may influence both. Most likely, all three explanations are correct. As is so often true in
economics, everything does depend on everything else, though in varying degrees.

Let’s look first at how the stock market influences the economy. When stock prices are high,
those who own stock feel richer (with good reason; they are richer). They tend to spend more and
live in a manner befitting their new wealth. When stock prices decline, households are likely to
retrench, increasing their saving and trying to rebuild their lost wealth.

The economy, in turn, undoubtedly affects the stock market. Stock prices are influenced by
anticipated dividends, and when the economy is strong profits surge and dividends follow close
behind. When recession hits, profits slump and dividends grow slowly, or even decline. In
general terms, if the economy improves there will be more conducive environment for stock
exchanges and the stock market. There will be more demand for incorporation of firms and
hence for stocks and this will lead to an expansion of the stock market. There may also be
investment on some infrastructure which may induce the existence or expansion of stock markets
as the economy improves.

Another explanation for the observed correlation is that some third factors influence both the
stock market and the economy. The possibilities are endless ranging from some negative shock in
production that will adversely affect both the stock market and the economy, war that may have

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similar effect. A more plausible factor is interest rates. As Andrew Tobias, a popular financial
writer, put it, “The key to everything financial, and to nearly everything economic, is interest
rate”.

Review Questions:
1. A Corporate firm may raise fund either through sale of bonds or stocks. What is the
difference between the two ways of fund raising? (Give your answer both from the
firm’s point of view and the investor’s point of view)
2. What is the difference between common and preferred stock?
3. Discuss the important of the secondary stock markets for the smooth transfer of fund?
4. Why are stock holders termed as absentee owners?
5. “Stock holders have limited liability” Explain this statement.
6. How can a sole proprietorship be transformed in to a corporate firm? How will
incorporation help the firm to enjoy the benefit of its illiquid asset?
7. What is the difference between book value and market value of a stock?
8. What is the importance of speculation for stock pricing? How can speculation make
price of a stock deviate from its real value?
9. Using an example, show how the present value of a stock is computed
10. What is the impact of interest rate on the price of stocks?
11. What is the Tobin’s q
12. What is the link between the stock market and the whole economic system?

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