Economics 434 Theory of Financial Markets

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Economics 434Theory of Financial Markets
Professor Edwin T Burton Economics
Department The University of Virginia
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Questions

• Why is the economy as a whole still okay?
• Why did Bear Stearns collapse
• What are Fannie and Freddie?
• Why are Lehman Brothers and Wachovia on the ropes?

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Stocks Bonds Equity Debt

• Assets financed by either
• Debt (Liabilities)
• Equity (Net Worth)
• Debt fixed income
• Equity residual income

Balance Sheet
Liabililties
Assets
Net Worth
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Financial Markets
Is about the markets for debt and equity
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Default Free Securities
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What is a default free security?

• Honors its promises
• In the real world
• Govt securities
• Securities backed by government
• All others may, under certain circumstances,
  default

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Why do we care?About Default Free Securities?

• Simplifies the analysis
• One less thing to worry about
• Does apply to government securities markets
• There is risk
• Why?
• Time!

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What do we mean by

• Rate of interest?
• Yield?
• Rate of return?
• Etc.?

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Imagine!

• You loaned me 100
• At 10 percent interest
• What would this mean?
• What would happen?

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Very likely, the following would occur
At the end of (one year), you would pay me
100 --- return of principal
Plus
100 times (r) where r .10
10 --- interest at 10 rate
110 --- total payoff after one year
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Which gives a useful formulathat works both ways
Future value of 100 when r 10 is (1 r)
times 100
Present value of 110 when r 10 is 110
divided by (1 r)
Dollar Amount
Present Value ------------------
(1 r)
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Suppose r 10 for all future times
then
100 (1 r) times (1 r) Future value of
100
Two years from now
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If r is always 10, what is the value today of
100 two years from now?
PV (1 r) (1 r) 100
PV is the answer!!!
100
PV
(1 r)2
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Generally,
If r1, r2, r3,rn. are the future one year
rates
Then Present Value of 100 received n periods
from now
is
100
(1 r1) (1 r2) (1 r3) (1 rn)
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The End