BE331 The Pricing of Securities in

Financial Markets

Dr. Nick Rowe

nick.rowe@essex.ac.uk

Lecture 1
 Structure of the Course
 Timetable:
• 2-hour weekly lectures + 1-hour fortnightly seminar
 Moodle
 Textbook:
• Peleg, Doron. Fundamental Models in Financial Theory,
MIT, 2014
• Fabozzi, F., Neaev, E., & Zhou, G. Financial Economics, Wiley,
2012
 Evaluation:
• Unseen examination (70%)
• Unseen in-class test (30%)
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 Financial Economics (FE)
WHY
FE examines the decision-making of individual,
households, investors, and entrepreneurs in the
context of the financial system

HOW
FE applies many of the microeconomic analytical
models in the financial decision making process

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 Individuals’ Financial Decision
Theories
Consumer choice theory
•Decision: allocation of consumption over time
Household finance decision
• Decision: choice of the proper financial instrument
(residential mortgage, automobile/student loans, credit
card borrowings etc..)
Portfolio selection theory
• Decision type: allocation of a given amount of money
among the investment opportunities available, such as
Physical assets (i.e. commercial property) and Securities
(i.e. stock and bonds)
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 Managers’ Financial Decision
Theories
Capital structure theory
Aim: determine the optimal capital structure of the firm in terms of the
mix of debt (i.e. borrowed funds) and equity (own funds) to finance
the firm’s operations
Capital investment decisions
Aim: determine capital investment decisions in assets expected to
produce income and cash flows (i.e. physical vs property rights-
representing assets)
– Investments in long-lived assets: Capital budgeting
theory
– Short-term assets: Working/current assets decisions

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Basic Elements of an Economic Model
• Agents: how many “decision-makers” are
we attempting to model? Which ones?
• Preferences/Objectives: what do agents
care about?
– Generally, comes in the form of a function that
“ranks” various choice-options
• Technologies: how do agents transform
inputs into outputs?
– Will often come in the form of a return matrix
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Basic Elements of an Economic Model
• Endowments: what resources/inputs do are
agents given to start with?
– (can’t get something from nothing!)
• Environment: what other elements
constrain/shape how choice are made?
– Static vs. dynamic model, how agents must interact
• Equilibrium: when is the model “solved”?
– we need conditions that help us characterize the
“choice” of agents in our model

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 Consumption & Investment
in a Simple 2-Period Model

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 Consumer Choice Theory
 In the developed economy, consumption makes
up a little more than two thirds of aggregate
expenditure
 Therefore consumers decide both how much to
consume at a given time and how much to
lend or invest (through financial assets) for
financing future consumption
 Consumers face trade-offs because their
income is limited, while the choices of goods
and services are numerous
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 Choice environment
• Agents: many individuals that live for two
periods, consume final good in each period
• Environment: agents borrow/lend the
consumption good in the capital market at
interest rate r,
– No informational asymmetry
– No transaction costs
– No single agent can affect price of consumption good
or interest rate
– (last three assumptions = perfect capital market)
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 Capital market
• Only one good in model: no need for money
– Borrowing/lending consumption good directly
• Principal denominated in units of consumption good
• Gross interest rate (1+r) represents the rate at which
period 2 goods are exchange for period 1 goods
• For the sake of simplicity, we assume agents
have perfect foresight
– Just means there’s nothing random in this
world, as far as our agents are concerned

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 Preferences
• Preferences: agents have rational preferences over
consumption in periods 1 and 2 that are representable
by the following utility function:
U = log(C1) + βlog(C2)
– Higher U => better “choice”
• Rational here means preferences are:
– Complete: we can rank every bundle (C1,C2)
– Transitive: if we prefer bundle A to bundle B and bundle B
to bundle C, then we must prefer bundle A to bundle C
• In a nutshell: agent wants bundle that provides the
highest U (agents maximize utility)
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 Preferences and indifference
• We want the highest U – but what if we have
bundles A and B that provide the same U?
– Then we say we are indifferent between A and B
– Indifference curves describe combinations of
current-future consumption that produce the
same level of utility:

– Therefore, bundles A and B must be on the same

indifference curve

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 Indifference Curves
 Point A: less consumption now, more in the future
 Point B: more consumption now, less in the future
 Both points lie on the same indifference curve, hence they
give the same utility to the consumer
 Indifference curves to the northeast direction are
consistent with higher utility
• The higher the consumption expenditure, the greater the consumer
satisfaction
 Any average of two equally satisfactory consumption
combinations yields a higher level of utility than either of the
combinations comprising the average
• This in order to have strictly convex indifference curves

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Financing Consumption Expenditures
• Recall our agents’ utility function:
U = log(C1) + βlog(C2)
– W/O constraints, consumers will try to have (C1,C2)
both go to infinity
– Consumers' choices are constrained by what they can
afford.
• Technology/Endowment: in periods 1 & 2, agents
are endowed with Y1 and Y2 units of the
consumption good
– “manna from heaven” – unrealistic, but we don’t care
about modelling production behaviour right now
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Financing Consumption Expenditures
• In period 1, agent has the following budget
constraint:
C1 ≤ Y1 - S
• S represents the saving/borrowing decision.
– when S > 0, agent is a lender
• To see this, note that when S>0
C1 = (Y1-S) < Y1 <- not consuming all of Y1
– When S <0, agent is a borrower
• To see this, note that when S<0
C1 = (Y1-S) >Y1 <- consuming more than Y1
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Financing Consumption Expenditures
• In period 2, agent has the following budget
constraint:
C2 ≤ Y2 + S(1+r)
– If agent was a lender (borrower), agent consumes more
(less) than their period 2 endowment
• You may have noticed the ≤ sign. What would a
strict inequality (<) mean here?
– Consumer lights endowment on fire (pure waste)
– Never happens, since consumer gets strictly positive
utility from consumption.
• Waste not, want not!

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 Putting it all together
• Our consumers have 3 choices:
– The amount of consumption in period 1, C1
– The amount of consumption in period 2, C2
– The choice of how much to save/borrow, S
• However, as we have just mentioned, the
agents budget constraints will always hold
with strict equality, we can solve for S

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 Putting it all together
• Period 1:
C1 = Y1 – S  S = Y1 – C1
• Period 2:
C2 = Y2 + S(1+r)
 C2 = Y2 + (Y1-C1)(1+r)
 C1(1+r) + C2 = Y1(1+r) + Y2
C1 + C2/(1+r) = Y1 + Y2/(1+r)
• Known as the intemporal budget
constraint or the wealth constraint
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 The consumer’s choice
• A consumer with intertemporal endowment
(Y1,Y2) facing interest rate r solves:

subject to the following constraint:

• We can simplify it further by substituting

the constraint into the utility function by
solving for C1
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 The consumer’s choice
• The consumer’s simplified problem
becomes:
V=
• We find optimum by setting derivative of the
above with respect to C2 = 0
– i.e., set first-order condition equal to zero

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 Solving for the optimum
• = C2 = 0
= =0 (by chain rule)
– Noting that = -1/(1+r), we get:
=0
Þ
ÞTerm on left is the marginal rate of substitution
ÞTerm on right is marginal cost of C2 in terms of C1

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 Marginal rate of substitution
The slope of the indifference curve is the marginal
rate of substitution (MRS) between present and
future consumption
• The larger is current consumption, the smaller the MRS
• It measures the rate of trade-off between C1 and C2. It
shows how many extra units of consumption tomorrow
must be received to give up one unit of consumption today,
and get the same utility.
• It is equal to the ratio of marginal utilities from current
and future consumption (given constant total utility)

25
 Optimal C2
• =0
ÞC2 = (1+r)
ÞC2= (Y1(1+r) +Y2-C2)
ÞC2(1 – ) = (Y1(1+r) +Y2)
ÞC2 = (Y1(1+r)+Y2)

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 Solution
• Given that:
– (from setting MRS = MC)
– C1 = (from int. budget constraint)
• We must have that
C1 = & C2 =(Y1(1+r) +Y2)
• Note that C1(C2) is decreasing (increasing) in r

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 Putting this into words
 The consumer must choose a combination of current and future
consumption that maximises utility given the intertemporal budget
constraint

 The optimal consumption bundle is found at the point of tangency

between the highest attainable indifference curve and the wealth
constraint

 In a world without capital markets, where the consumer cannot borrow

or lend, his expenditure would be restricted to (y1,y2) combination lying on
the indifference curve I’

 In the presence of capital markets, the consumer can move to the

higher indifference curve I, hence more utility, by borrowing in order to
increase his current period consumption
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 Things to Keep in Mind
The optimal consumption choices (c1*, c2*) are
found at the point of tangency between the
highest attainable indifference curve and the
wealth constraint
 Those the consumer most prefers, among the affordable
ones
 Located on the highest indifference curve the person
can reach
 Consumer is better off if an increment to initial wealth
is obtained as this shifts the wealth constraint to the
right
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 Takeaways
• Consumers’ optimal time profile of
consumption (C1,C2) will almost never
coincide with the time profile of their
income (Y1, Y2)
• Finance allows consumers to obtain a better
time profile of consumption expenditures
than they could if they merely spent income
when received

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 Capital Market Imperfections
• The analysis is consistent with idea that individuals
are never worse off, and usually better off, in
economies with perfect capital markets
• Capital market imperfections will reduce the degree
to which capital markets can improve over a no-finance
equilibrium:
– Transaction costs (i.e. brokerage fees) restrict the amount
of initial wealth that is available and reduce consumer’s
well-being
– Similarly, other types of imperfections (i.e. unequally
distributed information) can inhibit or even prevent
financial transactions from taking place
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 Practical Implications of Consumption-Investment
Theory

 Household investment decisions are important to firms and

governments because households are the primary source of
capital

 Most of the household funds are in financial institutions (i.e.

pension funds, mutual funds and insurance companies) that invest
them in corporate and government securities

 Households can also have direct holdings of corporate and

government securities (acting directly as lenders)

 The price that firms/governments must pay for the households’ funds
is the price that households require to defer present
consumption until some future time
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 Interest Rates

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 Market Interest Rate
 The market interest rate is the price that those demanding
funds (i.e. governments and corporations) must pay the
consumers to bid away funds from consumer spending
• Reflects society’s preferences for trading off between current and
future consumption

 By paying the market interest rate, firms induce saving

which then provides the necessary funds for purchasing
investment goods

 Such investments are worthwhile if they yield a return that

is higher than the market rate of interest
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 Nominal Interest Rate
Definition: The usage price of money for a specific time period
• If the period is not explicitly specified, it is assumed as being an
annual interest rate

 In a compound interest rate setting (≠ simple interest), the

interest is paid on both the principal and the accrued
interest, when there is more than one period:
Cn = C0(1+r)n assuming a fixed r
• Not uncommon for firms to present an annual nominal interest rate,
with the fine print stating that the interest amount is computed on
a monthly basis
• Be careful and consider the effective interest rate which is the
true annual interest rate that is paid !
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 Practical Example
• A loan of £100 with a 12% nominal interest rate compounded
annually will require the borrower to pay £112 at the end of each
year
– If the interest rate is computed on a monthly basis, then each month an
interest rate of 12% / 12 = 1% would be charge
– In a monthly compound interest rate setting, we would get
£100 x (1+0.12/12)12 = £112.68
• The effective annual interest rate is therefore 12.68%, and not,
as indicated by the nominal annual interest rate, 12% !
– This is a way of “ballooning” effective interest rates while stating a
seemingly lower nominal interest rate
• Therefore, when examining alternatives for loan or savings, one
should calculate the effective interest rate, and not consider the
stated nominal interest rate

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 Inflation & Real Interest Rate
 Inflation: a change (decrease) in the purchasing power of
money (PPM)
• Often represented by π
• The price index used to measure inflation is typically the Consumer Price
Index, or the GDP deflator
• High inflation implies low purchasing power of money
• If an individual wants to guarantee real compensation for deferring
consumption, he has to take into account the decrease in the PPM
• Total required compensation becomes C1 = (1+ π) x (1+r) x C0
• Where (1 + R) = (1+ π) x (1 + r)

 Real interest rate: the nominal interest rate net of inflation

• Thus the nominal interest rate can be adjusted for inflation to
become “real”:

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 Practical Example
• An individual demands a real annual interest rate of 12%
• Inflation rate for during that period is expected to be 10%
• In order for him to receive a real increase in consumption
(which takes into account the decreasing PPM), what nominal
interest rate R should he require?

Remember that (1 + R) = (1+ Inflation) x (1 + r)

By substituting values into equation, we get:

(1 + R) = (1 + 0.10) x (1 + 0.12) = 1.232

R = 1.232 – 1 = 0.232 R = 23.2%

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 Benchmark Interest Rate
The benchmark interest rate is defined as
the interest rate for borrowers with no risk
of repayment default (i.e. risk-free rate)

 Note: we have assumed until now that

borrowers will always repay their loans
• This assumption is probably true if we just buy U.S.
government bonds as the latter can always print more
dollars and repay its debt

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 Default Premium
• However this is not the case with corporate bonds
• Banks / credit rating agencies know how to rate borrowers according to their
default risk
 Corporate borrowers are required to pay a risk premium
in addition to the benchmark interest rate to compensate
the lender for possible losses
 Risk premium is affected by 4 risk factors:
– Inflation (for which an inflation premium, IP, is required)
– Default (for which a default premium, DP, is required)
– Liquidity (for which a liquidity premium, LP, is required)
– Maturity (for which a maturity premium, MP, is required)
 Symbolically, we can therefore say that:
= + IP + DP + LP + MP
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Thank you for your attention!