G1. FM1a. Economics of Financial Markets

Financial Markets and Institutions
Economics of Financial Markets

Objectives
• What is the main economic function of a financial market?

• What are mutually beneficial intertemporal exchanges?
• What additional functions are performed by financial markets?
Economic Function of a Financial Market
• The main economic function of a financial market is to increase

the efficiency with which individuals can engage in mutually
beneficial intertemporal exchanges with other individuals.
Divergence…
• An intertemporal exchange is the one in which two sides of

the exchange occur at different times. For example, Person A
will give something of value to Person B at time 0 in exchange for a
commitment by Person B to give something of value to Person A at
a later time. In some cases, Person B will promise to deliver things
of value at several future times.
Divergence…
• An essential property of an intertemporal exchange is the risk that

Person B will be unable to make the promised delivery or will
refuse to do so.
• NOTE: Person B may not be able to make promised delivery because his
promise may depend on an outcome (such as the size of a crop) that will
not be known until some future time.
Mutually Beneficial Intertemporal Exchanges
• Individuals who wish to trade in financial markets make two types

of intertemporal trade-offs. The first one involves the trade-off
between current consumption and producing capital goods
(Trade-Off 1), while the second one involves the trade-off created
by the interplay of risk and expected return (Trade-Off 2).
Divergence…
• A capital good is a produced good that can be used as an input for

future production. Capital goods can be tangible (such as a
railroad locomotive) or intangible (such as a computer language).
• A society increases its standard of living over time through the
accumulation of capital goods.
• Both of these trade-offs maximize the lifetime satisfaction of

individuals by allowing individuals to create mutually beneficial
exchanges. However, mutually beneficial exchange requires that
individuals should differ in their willingness to tolerate
uncertainty.
• In order to understand why the difference in attitude towards risk

can lead to mutually beneficial exchange, consider the following
example.
Example 1
• Ms. Lyons and Ms. Clyde jointly provide the capital goods for an
enterprise, which produces an income of either $60 or $140 in any
given year. These two outcomes are equally likely, and the outcome
for any year is independent of the outcomes for all previous years.
Example 1
• Consequently, the average annual income from the capital good is

$100 [=(0.5*60) + (0.5*140)].
• If the two women share the annual income equally, each woman’s
average annual income will be $50.
• Furthermore, in any given year, the income of each women will be
either $30 or $70, with each possibility being equally likely.
Example 1
• If Ms. Lyons is sufficiently averse to uncertainty, she will prefer a

guaranteed annual income of $35 to an income that fluctuates
unpredictably between $30 and $70.
• That is, Ms. Lyons will trade away $15 of her average income in
exchange for relief from uncertain fluctuations in that income.
Example 1
• Ms. Clyde, on the other hand, might be willing to accept an

increase in the unpredictable fluctuation of her income in
exchange for a sufficiently large increase in her average income.
• Specifically, Ms. Clyde might prefer an income that fluctuates
unpredictably between $25 and $105 (which would mean an
average of $65 per year) to an income that fluctuates
unpredictably between $30 and $70 (which would mean an
average of $50 per year).
Example 1
• If the two women’s attitudes toward uncertainty are as we have

described them, these women can have a mutually beneficial
exchange.
• In exchange for a $15 increase in her own average income, Ms.
Clyde will insulate Ms. Lyons against the uncertain
fluctuations in her income.
Divergence…
• In addition to the trade-offs explained above, individuals also face

another type of trade-off in which they decide between how to use
the resources that they have reserved (this year) to support
current consumption. These resources must be allocated among
the production of current goods and services.
Divergence…
• In its simplest form, this is the problem of maximizing utility by

allocating a fixed level of current income between the purchases of
Goods X and Y.
• This kind of trade-off is not an intertemporal allocation, and thus it
does not involve financial markets.
Divergence…
• This trade-off is, generally, studied under the Theory of Consumer

Behavior.
• Financial markets promote the following three kinds of

intertemporal exchanges:
• Intertemporal Exchange 1: Mutually beneficial exchanges between
current and future consumption that do not involve net capital
accumulation for the economy
• Intertemporal Exchange 2: Mutually beneficial exchanges between
current and future consumption that do involve net capital accumulation
for the economy
• Intertemporal Exchange 3: Mutually beneficial exchanges of claims to
uncertain future outcomes
Intertemporal Exchange 1
• In order to understand Intertemporal Exchange 1, consider the

following example. The example illustrates the case in which the
two persons exchange claims to current and future consumption
without increasing the stock of capital goods in the economy.
• Assume that Mr. Black and Mr. Green are employed. Each man’s
income for the current year is the value of his contribution to the
production of goods and services this year.
• Each man’s income entitles him to remove a volume of goods and
services from the economy that is equal in value to what he
produced during the year.
Divergence…
• Economists define consumption as the removal of goods and

services from the business sector by households.
• If every person spent his entire income every year, the economy
would not be able to accumulate any capital goods in the business
sector. Therefore, savings is very important for the economy that
wants to grow.
• Now suppose that Mr. Black wants to spend $x more than his
current income (during this year).
• That is, he wants to remove a volume of goods and services from
the business sector whose value exceeds by $x the value of what
he produced during the current year.
• If Mr. Black is to consume more than what he produced during this

year, someone else must finance this “excess” consumption by
consuming a volume of goods and services whose value is $x less
than what he produced during this year.
• Suppose that Mr. Green agrees to do this, in exchange for the right
to consume next year a volume of goods and services whose value
exceeds the value of what he will produce next year. Mr. Black is
now a borrower and Mr. Green is a lender.
• Typically, the agreement requires the borrower to repay the lender

with interest. For example, in exchange for a loan equal to $x, Mr.
Black will repay $y ($y > $x) to Mr. Green next year.
• Both Mr. Black and Mr. Green can increase their levels of lifetime
utility by undertaking this mutually beneficial exchange.
• Mr. Black gains utility by reducing his consumption next year by $y
and increasing his current consumption by $x. Were this not so,
Mr. Black would not have agreed to the exchange.
• Similarly, Mr. Green gains utility by reducing his current

consumption by $x and increasing his consumption next year by
$y.
• Both men gain utility because they are willing to substitute
between current and future consumption at different rates.
• In a numerical setting (using hypothetical numbers), current

example would assume that Mr. Black is willing to decrease the
rate of his consumption next year by as much as $125 in exchange
for increasing his rate of current consumption by $100.
• While, Mr. Green’s present allocation between current and future

consumption is such that he will decrease his current rate of
consumption by $100 in exchange for an increase in his rate of
future consumption (during the next year) by at least $115.
• The hypothetical numbers suggest that Mr. Black is willing to

borrow at rates of interest up to 25%, and Mr. Green is willing to
lend at rates of interest no less than 15%.
• As a result of this difference in borrowing and lending rates, the
two men can construct a mutually beneficial exchange.
• In the preceding discussion, Mr. Green is a lender because he

finances Mr. Black’s “excess” consumption.
• There is another possibility for Mr. Green to be a lender. If Mr.
Green consumes less than his current income, he can finance the
accumulation of capital goods in the production sector.
• If Mr. Green spends less than his current income, the economy can
re-allocate resources out of the production of goods and services
intended for households and into the production of capital goods,
such as railroad locomotives and computer languages.
• By accumulating these capital goods in the production sector, the

economy can expand its ability to produce goods and services in
the future, including goods and services intended for households.
• We argue that if Mr. Green’s saving enables the economy to

accumulate capital goods, then Mr. Green can be repaid out of the
net increase in future production that the expanded stock of
capital goods will make possible.
• Intertemporal allocations always involve uncertainty because the

future is uncertain. In the following slides, we present a simple
example of how two persons, who differ in their willingness to
tolerate uncertainty, can construct a mutually beneficial exchange.
• Assume that Ms. Tall and Ms. Short operate adjacent farms that are
identical in all respects.
• The output of corn on each farm is equal to either 800 tons or
1200 tons, depending on whether nature is beneficial or
detrimental that year.
• The state of nature for any particular year is unpredictable.
• Over the longer run, each of the two states occurs with a
probability equal to 50%. Therefore, each woman’s annual product
fluctuates unpredictably between 800 and 1200 tons of corn. Their
average annual product is 1000 tons [=(0.5*800) + (0.5*1200)] of
corn.
• The two women differ in their willingness to tolerate uncertainty.

Ms. Tall is risk averse. She prefers to have a guaranteed annual
product of 900 tons of corn, rather than unpredictable fluctuations
between 800 and 1200 tons of corn.
• Therefore, if Ms. Tall is guaranteed 900 tons of corn each year, she
will accept a decrease of 100 tons of corn in her average annual
product.
• Ms. Short is risk preferring. She will accept an increase in the

range over which her product fluctuates, if she can gain a
sufficiently large increase in the average level of her product.
• Ms. Tall and Ms. Short construct the following mutually beneficial
exchange based on the difference in their attitudes toward
uncertainty: they combine their farms into a single firm.
• In a year in which nature is beneficial, each farm will produce
1200 tons of corn, so that output of the firm will be 2400 tons.
When nature is detrimental, each farm will produce only 800 tons,
and the output of the firm will be 1600 tons.
• The risk-averse Ms. Tall will hold a contractual claim: she will
receive 900 tons of corn each year regardless of the state of nature.
• Ms. Short will absorb the vagaries of nature by holding a residual
claim: each year she will receive whatever is left over from the
aggregate output after Ms. Tall is paid her contractual 900 tons.
• Therefore, Ms. Short’s annual income will fluctuate unpredictably

between 700 tons and 1500 tons (resulting in average annual
income of 1100 tons).
• In summary, the risk-averse Ms. Tall will reduce the level of her
average annual income from 1000 tons to 900 tons, in exchange
for being insulated from unpredictable fluctuations in her income.
• While, the risk-preferring Ms. Short will accept an increase in the
range over which her annual income will fluctuate, in exchange for
an increase in the average level of her income.
• Financial markets facilitate these exchanges by enabling firms to

offer different kinds of securities. The contractual claim that Ms.
Tall holds is similar to a bond, while the residual claim that Ms.
Short holds is similar to a common stock.
Additional Functions of Financial Markets
• In addition to helping in intertemporal exchanges, financial

markets also perform certain other functions. Most important of
them are:
• Price Discovery
• Liquidity
• Transaction Cost Reduction
Price Discovery
• Price discovery means that the interactions of buyers and sellers

in a financial market determine the price of traded asset.
Price Discovery
• Given that price is a function of required return, this process also

enables the identification of returns that participants in a financial
market demand in order to buy a financial instrument.
• Funds will flow to those borrowers that offer the highest return to
lenders for a given level of risk.
Divergence…
• Price of any asset is a function of required return (r), expected

cash flows (D) and growth in expected cash flows:.
D1
P0 
r  g 
Liquidity
• The liquidity of an asset is a measure of the increase in the cost

that one would incur as a consequence of increasing either the size
of a transaction in that asset or the speed at which the investor
wants to conclude the transaction.
• A highly liquid asset is one for which the price at which the
asset can be bought or sold is little affected by increases in the
speed or the size of the transaction.
Liquidity: Example 1
• A house is a relatively illiquid asset: its price depends on the speed

with which the seller or the buyer wants to conclude the sale.
• A realtor might advise a homeowner that she can expect to sell the
house for a price between $115000 and $120000 if the
homeowner is willing to wait for several weeks while prospective
buyers canvass the market, inspect the house, obtain an engineer’s
report on the house, arrange for financing, and have their
attorneys inspect the title to the property.
• A homeowner can sell her house more quickly, but only if she
accepts a price that is low enough to induce a prospective buyer to
forego collecting the information that would reduce the risks
involved in purchasing her home.
• One could probably sell his home within a day, for cash, by
accepting a price that is 20% less than what the owner could get if
he were willing to leave the house on the market for several weeks.
• In fact, if the owner were willing to accept a sufficiently low price,

a realtor would probably purchase the home immediately for cash,
and then put it on the market for resale.
• Similarly, if a person insists on purchasing a home immediately, he
or she can do so by offering to pay sufficiently more than the
asking price.
• Unlike a house, the shares of IBM common stock are quite liquid.
The prices at which an investor can buy or sell a share of IBM stock
does not depend on the speed of the transaction.
• One reason for this is that shares of IBM common stock are
standardized. Any share is a perfect substitute for any other share,
just as any five-dollar bill is interchangeable with any other five-
dollar bill. No one is interested in inspecting a particular share of
IBM as a condition of purchasing it.
• Another reason is that the shares of IBM common stock are

actively traded on the New York Stock Exchange.
• During the hours that the market is open, dealers in IBM common
stock announce a bid price at which they will purchase shares of
IBM, and an ask price at which they will sell shares of IBM. For
instance, a dealer’s bid price can be $80.25, and his ask price can
be $80.75.
• In this case, any investor can immediately sell a share of IBM for
$80.25 to the dealer or purchase a share of IBM for $80.75 from
him.
• An important question that arises here is: What would happen if

the investor wants to purchase or sell 800000 shares
immediately?
• An attempt to purchase a large number of shares immediately

would probably drive the dealer’s prices up.
• Similarly, an attempt to sell a large number of shares immediately
would drive the dealer’s prices down.
• We may conclude that small quantities of IBM common stock are

highly liquid: the price of the asset will not be affected by the
speed at which the transaction is conducted. However, as the size
of the transaction increases, the liquidity of the asset decreases.
Divergence…
• A dealer in any good provides a service of predictable immediacy

by enabling persons to buy or sell that good without notice. To
provide this service, the dealer must maintain a stock of the good
in question and a stock of money (or access to credit).
• Dealers in IBM stock on an organized exchange are no exception. If
their inventories of IBM stock are depleted, they must replenish
them or risk being unable to accommodate investors who wish to
purchase shares of IBM immediately.
Divergence…
• Dealers can replenish their inventories of IBM stock by

simultaneously raising their bid and ask prices. Raising the bid
price will induce some investors to sell larger quantities of IBM
shares to a dealer, or sell given quantities sooner, than these
investors would otherwise do.
• Similarly, raising the ask price will induce investors who would
otherwise purchase shares of IBM from the dealer to do so in
smaller quantities or at lower speeds.
Liquidity
• There are two reasons why liquidity matters.

• One reason is that intertemporal exchanges involve claims on future
payoffs, and the future is uncertain.
• The second reason is that some investment projects require large
infusions of resources at the outset, and thereafter generate very long
sequences of relatively small payments.
Liquidity
• The more liquidity financial markets provide, the larger the

set of mutually beneficial intertemporal exchanges that
individuals can conduct.
• Therefore, greater liquidity in financial securities increases the
opportunities for individuals to increase their levels of lifetime
utility.
Liquidity
• In order to understand this, consider a hypothetical company – the

Mosquito Point Barge Company. Assume that the company wants
to purchase a new tugboat. With the new tugboat, the company
can offer faster and more reliable service, and thus obtain higher
profits.
Liquidity
• However, the company does not have sufficient funds of its own to
purchase the new tugboat.
• Mr. Apple is willing to finance the Mosquito Point Barge
Company’s investment project. In order to do so, he will obtain a
financial security issued by the company.
Liquidity
• Mr. Apple, however, face one source of uncertainty. He has aging

parents. They might need someone to take care of them. Thus, Mr.
Apple might want to purchase fulltime care for them on relatively
short notice.
Liquidity
• The more liquid the financial security offered by the Mosquito

Point Barge Company, the lower the cost that Mr. Apple will incur
if he decides to sell the security on short notice. Therefore, the
more liquid the security, the more easily the company can finance
its project by inducing investors like Mr. Apple.
• The Spring Lake Railroad wants to build a tunnel. The tunnel will
enable the railroad to move freight trains more quickly between
two major cities and thus generate a relatively small increase in
profit each year. The tunnel will be extremely expensive to build,
but it will last indefinitely with little maintenance. The railroad
cannot finance the construction of the tunnel with its own funds.
• No investor plans to live long enough to justify helping to finance

the tunnel in exchange for a right to receive an indefinitely long
sequence of relatively small payments.
• But if the investors can obtain financial securities, each investor
can hold the security for some number of years, then sell it to a
younger investor. The older investor will sell to the younger
investor the right to receive the remaining payments that the
tunnel will generate.
• By purchasing the security, the younger investor enables the older

investor to withdraw her investment. The more liquid the security
offered by the railroad, the greater the extent to which individuals
can increase their levels of lifetime utility by making intertemporal
exchanges.
Transaction Cost Reduction
• An important way in which financial markets assist individuals in

making intertemporal exchanges is by reducing transaction costs.
• The term transaction costs is broadly defined to include all those
costs that individuals incur to make exchanges.
• In general, one can classify costs associated with transacting into

two types:
• Search Costs
• Information Costs
• Search costs fall into two categories:

• Explicit Costs: Explicit costs include expenses that may be needed to
advertise one’s intention to sell or purchase a financial instrument.
• Implicit Costs: Implicit costs include the value of time spent in locating a
counterparty to the transaction.
• Information costs are costs associated with assessing a financial

instrument’s investment attributes. In an efficient market, prices
reflect the aggregate information collected by all market
participants.
• Financial markets reduce these costs by providing easy access to a

central location at which individuals can trade standardized
securities.
• Two individuals can make a mutually beneficial exchange only if

they have different preferences (such as willingness to tolerate
uncertainty).
• But these individuals must first find each other, and then they
must agree on the terms of the exchange. These terms can be quite
complex (requiring significant skills) if the exchange is an
intertemporal one.
• Financial securities are usually traded on exchanges. Associated

with the exchanges on which these securities are traded are
clearinghouses which guarantee that the investors who trade in
these securities will meet their obligations.
• By insuring individual investors against the risk of default by other
investors, the clearinghouses increase the attractiveness of these
securities as the basis for mutually beneficial exchanges.
Problems
Problem 1
• Mr. Block’s potato farm produces between 500 and 800 tons of
potatoes each year if there is bad weather, and between 700 and
1000 tons each year if there is good weather. The farm has several
investors who together own a bond that entitles them to receive
600 tons of potatoes each year. Today there is 0.50 probability that
weather will be good next year. If tomorrow that probability is
changed to 0.40 for the succeeding year, what will happen to the
price for which the investors could sell their bond?
Problem 2
• ABC Furniture has been struggling to get customers into its store.
In an attempt to increase sales, the firm has advertised that
interest-free payments on furniture are not due until one year
after the furniture is purchased. Under what condition would this
be a mutually beneficial exchange between ABC Furniture and
prospective new customers?
Problem 3
• Mr. Brown wants to increase his current consumption by $100.

The current interest rate paid by a bank for deposits is 10%, and
the bank is willing to lend at 15%. If Mr. Brown can guarantee that
he will repay a loan that he might obtain from Mr. Green, is it
economically efficient for Mr. Green to keep $100 in the bank?
Problem 4
• Ms. White and Ms. Black own farms next to each other. When the
weather is good, each farm produces 2000 tons of apples per year.
When the weather is bad, each farm produces 1000 tons per year.
Ms. White is risk-averse. Ms. Black is willing to accept additional
risk in exchange for a sufficient increase in her average rate of
return.
Problem 4
• If good and bad weather occur with equal probability, and if Ms.
White will accept a guaranteed return of 1000 apples per year, can
the two women effect a mutually beneficial exchange? What type
of claim would each woman hold?
References
References
• Bradfield, J., (2007). Chapter 1 (The Economics of Financial

Markets). Introduction to the Economics of Financial Markets,
Oxford University Press.

G1. FM1a. Economics of Financial Markets

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

G1. FM1a. Economics of Financial Markets

Uploaded by

Copyright:

Available Formats

Financial Markets and Institutions

Economics of Financial Markets

• What is the main economic function of a financial market?

• The main economic function of a financial market is to increase

• An intertemporal exchange is the one in which two sides of

• An essential property of an intertemporal exchange is the risk that

• Individuals who wish to trade in financial markets make two types

• A capital good is a produced good that can be used as an input for

• Both of these trade-offs maximize the lifetime satisfaction of

• In order to understand why the difference in attitude towards risk

• Consequently, the average annual income from the capital good is

• If Ms. Lyons is sufficiently averse to uncertainty, she will prefer a

• Ms. Clyde, on the other hand, might be willing to accept an

• If the two women’s attitudes toward uncertainty are as we have

• In addition to the trade-offs explained above, individuals also face

• In its simplest form, this is the problem of maximizing utility by

• This trade-off is, generally, studied under the Theory of Consumer

• Financial markets promote the following three kinds of

• In order to understand Intertemporal Exchange 1, consider the

• Economists define consumption as the removal of goods and

• If Mr. Black is to consume more than what he produced during this

• Typically, the agreement requires the borrower to repay the lender

• Similarly, Mr. Green gains utility by reducing his current

• In a numerical setting (using hypothetical numbers), current

• While, Mr. Green’s present allocation between current and future

• The hypothetical numbers suggest that Mr. Black is willing to

• In the preceding discussion, Mr. Green is a lender because he

• By accumulating these capital goods in the production sector, the

• We argue that if Mr. Green’s saving enables the economy to

• Intertemporal allocations always involve uncertainty because the

• The two women differ in their willingness to tolerate uncertainty.

• Ms. Short is risk preferring. She will accept an increase in the

• Therefore, Ms. Short’s annual income will fluctuate unpredictably

• Financial markets facilitate these exchanges by enabling firms to

• In addition to helping in intertemporal exchanges, financial

• Price discovery means that the interactions of buyers and sellers

• Given that price is a function of required return, this process also

• Price of any asset is a function of required return (r), expected

• The liquidity of an asset is a measure of the increase in the cost

• A house is a relatively illiquid asset: its price depends on the speed

• In fact, if the owner were willing to accept a sufficiently low price,

• Another reason is that the shares of IBM common stock are

• An important question that arises here is: What would happen if

• An attempt to purchase a large number of shares immediately

• We may conclude that small quantities of IBM common stock are

• A dealer in any good provides a service of predictable immediacy

• Dealers can replenish their inventories of IBM stock by

• There are two reasons why liquidity matters.

• The more liquidity financial markets provide, the larger the

• In order to understand this, consider a hypothetical company – the

• Mr. Apple, however, face one source of uncertainty. He has aging

• The more liquid the financial security offered by the Mosquito

• No investor plans to live long enough to justify helping to finance

• By purchasing the security, the younger investor enables the older

• An important way in which financial markets assist individuals in

• In general, one can classify costs associated with transacting into

• Search costs fall into two categories:

• Information costs are costs associated with assessing a financial

• Financial markets reduce these costs by providing easy access to a

• Two individuals can make a mutually beneficial exchange only if

• Financial securities are usually traded on exchanges. Associated

• Mr. Brown wants to increase his current consumption by $100.

• Bradfield, J., (2007). Chapter 1 (The Economics of Financial

You might also like