Download Here. - Stephen Kinsella

Financial Economics
Lecture 3
Stephen Kinsella
Dept. Economics,
University of Limerick.
[email protected]
February 1, 2010
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Today
1
More on the basics of Financial Economics.
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Today
1
More on the basics of Financial Economics.
2
concepts, data, and terminology
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Today
1
More on the basics of Financial Economics.
2
concepts, data, and terminology
3
monetary policy and interest rate determination
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In the News
China’s CPI
Monetary policy in the BRICS vs the US.
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In the News
China’s CPI
Monetary policy in the BRICS vs the US.
Gold (GLD) and VIX movements.
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Gold vs VIX
[See trueeconomics.blogspot.com, wolframalpha.com (search for {GLD, VIX})]
VIX is an index of volatility–wiggle–in the S&P 500.
The wiggle shows how much movement/fear there is in this giant
system, because it broadly reflects 30 days’ worth of expectation
about the movement of really big firms.
50
40
30
20
Mar
May
Jul
Sep
Nov
Jan
Figure: VIX for last year.
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Put Another Way
Interesting way to measure fear.
^ VIX
+60%
+40%
+20%
-10%
-5%
+5%
+10%
+15%
SP500
-20%
-40%
Figure: VIX vs SP 500, last year. α = 106.85%, β = −3.09, R 2 = 0.553. VIX is
square root of the par variance swap rate for a 30 day period on the S/P.
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Yet another way: VIX vs gold.
�150�
�100�
�50�
0�
�50�
�100�
Jul
�simulated
GLD �
Jan
Jul
log �normal random walks based on historical parameters �
^ VIX
Figure: VIX vs GLD, 6 month projection, based on a random walk.
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Part I
Concepts, data, and terminology
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Concepts, Data & Terminology
See handout from last time.
Stocks
Bonds
Assets
Forwards & Futures
Options
Time Value
Risk and return
Valuation
Porfolio
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Terminology
Underlying Assets
Underlying assets can be stocks, bonds, currency, commodities, and other
financial assets, or combinations of these. The traditional stock and bond
markets raise necessary capital for corporations and governments, and the
foreign exchange market facilitates international trade and investment.
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Terminology
Underlying Assets
Underlying assets can be stocks, bonds, currency, commodities, and other
financial assets, or combinations of these. The traditional stock and bond
markets raise necessary capital for corporations and governments, and the
foreign exchange market facilitates international trade and investment.
Stocks
Stocks represent the claim of the owners of a firm. Stocks are issued by
corporations and can be traded in the stock market. Common stock
usually entitles the shareholder to vote in the election of directors and
other matters.
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Bonds
Bonds are issued by anyone who borrows money - firms, governments, etc.
They are fixed-income instruments because they promise to pay fixed sums
of cash in the future. Bondholders have an IOU (I owe you) from the
issuer, but no corporate ownership privileges, as stockholders do.
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Bonds
Bonds are issued by anyone who borrows money - firms, governments, etc.
They are fixed-income instruments because they promise to pay fixed sums
of cash in the future. Bondholders have an IOU (I owe you) from the
issuer, but no corporate ownership privileges, as stockholders do.
Derivative Assets
Derivatives are financial instruments that take their value from the prices
of one or more other assets such as stocks, bonds, foreign currencies, or
commodities. Derivatives serve as tools for managing risks associated with
these underlying assets. The most common types of derivatives are options
and futures.
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Terminology
Forwards and Futures
A forward is a financial contract in which two parties agree to buy and sell
a certain amount of the underlying commodity or financial asset at a
prespecified price at a specified time in the future. The specified time is
called the time-to-maturity of the forward contract and the price specified
in the contract is called the forward price.
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Terminology
Forwards and Futures
A forward is a financial contract in which two parties agree to buy and sell
a certain amount of the underlying commodity or financial asset at a
prespecified price at a specified time in the future. The specified time is
called the time-to-maturity of the forward contract and the price specified
in the contract is called the forward price.
Options
An option is a financial contract, which provides the holder with the right
to buy or sell a certain amount of the underlying asset at a prespecified
price at or before a specified time in the future.
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Example
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Example
Say you decide to buy a new car. Dealer tells you that if you place the
order today and place a deposit, then you can take delivery of the car in 3
months time.
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Example
Say you decide to buy a new car. Dealer tells you that if you place the
order today and place a deposit, then you can take delivery of the car in 3
months time. If in 3 months time the price of the model has decreased or
increased, it doesn’t matter. When the agreement between you and the
dealer is reached, you have entered into a forward contract: you have the
right and also the obligation to buy the car in 3 months.
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Example
Say you decide to buy a new car. Dealer tells you that if you place the
order today and place a deposit, then you can take delivery of the car in 3
months time. If in 3 months time the price of the model has decreased or
increased, it doesn’t matter. When the agreement between you and the
dealer is reached, you have entered into a forward contract: you have the
right and also the obligation to buy the car in 3 months. Instead, suppose
the car you selected is on offer at 30,000 euros but you must buy it today.
You don’t have that amount of cash today and it will take a week to
organize a loan. You could offer the dealer a deposit, for example 200
euros, if he will just keep the car for a week and hold the price.
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Example
Say you decide to buy a new car. Dealer tells you that if you place the
order today and place a deposit, then you can take delivery of the car in 3
months time. If in 3 months time the price of the model has decreased or
increased, it doesn’t matter. When the agreement between you and the
dealer is reached, you have entered into a forward contract: you have the
right and also the obligation to buy the car in 3 months. Instead, suppose
the car you selected is on offer at 30,000 euros but you must buy it today.
You don’t have that amount of cash today and it will take a week to
organize a loan. You could offer the dealer a deposit, for example 200
euros, if he will just keep the car for a week and hold the price. During the
week, you might discover a second dealer offering an identical model for a
lower price, then you don’t take up your option with the first dealer. At
the end of the week the 200 euros is the dealer’s whether you buy the car,
or not. In this case, you have entered an option contract, a call option
here. It means that you have the right to buy the car in a week, but not
the obligation. The expiration time is one week from now, the strike price
is 30,000 euros.
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Time Value
Time Value
Time value of money refers to the fact that money in hand today is worth
more than the expectation of the same amount to be received in the
future. Money has a time value because of the opportunity to earn interest
or the cost of paying interest on borrowed capital.
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Time Value
Time Value
Time value of money refers to the fact that money in hand today is worth
more than the expectation of the same amount to be received in the
future. Money has a time value because of the opportunity to earn interest
or the cost of paying interest on borrowed capital.
Compounding - the process of going from today’s value, or present value
(PV ), to future value (FV ). Future value is the amount of money an
investment will grow to at some date in the future by earning interest at
some compound rate. Ifi is the interest rate and n is the number of years,
the future value of a present value is given by:
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Time Value
Time Value
Time value of money refers to the fact that money in hand today is worth
more than the expectation of the same amount to be received in the
future. Money has a time value because of the opportunity to earn interest
or the cost of paying interest on borrowed capital.
Compounding - the process of going from today’s value, or present value
(PV ), to future value (FV ). Future value is the amount of money an
investment will grow to at some date in the future by earning interest at
some compound rate. Ifi is the interest rate and n is the number of years,
the future value of a present value is given by:
FV =
Stephen Kinsella (University of Limerick)
PV
(1 + i)t
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(1)
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Example
Asset Pricing
Asset priced at ¤2 today is held for 30 years giving off a stream of interest
payments at 7%. What is the present value of this stock? We need to
augment equation (1) above with the notion that we will be receiving a
regular stream of payments from the asset over the 30 years. We still
discount the future payments by the current interest rate, but add on
another term to take care of us getting the payments also. Our PV
becomes
PV =
C
1 (1 + i)t
i
(2)
so
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Example
Asset Pricing
Asset priced at ¤2 today is held for 30 years giving off a stream of interest
payments at 7%. What is the present value of this stock? We need to
augment equation (1) above with the notion that we will be receiving a
regular stream of payments from the asset over the 30 years. We still
discount the future payments by the current interest rate, but add on
another term to take care of us getting the payments also. Our PV
becomes
PV =
C
1 (1 + i)t
i
(2)
so
PV = (2/1.0730 ) = 0.26
(3)
becomes
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Example
Asset Pricing
Asset priced at ¤2 today is held for 30 years giving off a stream of interest
payments at 7%. What is the present value of this stock? We need to
augment equation (1) above with the notion that we will be receiving a
regular stream of payments from the asset over the 30 years. We still
discount the future payments by the current interest rate, but add on
another term to take care of us getting the payments also. Our PV
becomes
PV =
C
1 (1 + i)t
i
(2)
so
PV = (2/1.0730 ) = 0.26
(3)
PV = 1/0.07 ∗ (1 − (1/1.07∧ (30))) = 12.40.
(4)
becomes
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Risk and Return
One aside: There is a fundamental assumption that with a higher amount
of risk must come a higher rate of return on any asset–it would be
irrational to hold a riskier asset than you desire for less return than doing
something else with your cash. This view, assumes you know a lot about
other assets, and it is something we’ll return to in much more detail later
on.
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Part II
Macro Structures
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Decisions, decisions
See Handout
2
Real
Activities
3
1
4
Household
5
Financial
Assets/
Liabilities
( )
Bonds
Stocks
Options
Mortgages
.....
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See Pilbeam, pgs 28-33.
Functions:
provision of a payment system
maturity transformation
(All for a profit, of course)
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See Pilbeam, pgs 28-33.
Functions:
provision of a payment system
maturity transformation
risk transformation
(All for a profit, of course)
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See Pilbeam, pgs 28-33.
Functions:
provision of a payment system
maturity transformation
risk transformation
liquidity provision
(All for a profit, of course)
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See Pilbeam, pgs 28-33.
Functions:
provision of a payment system
maturity transformation
risk transformation
liquidity provision
reduction of Transaction/information/search costs
(All for a profit, of course)
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Summary
Stop! Write down two things you remember from this lecture.
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Summary
Stop! Write down two things you remember from this lecture.
My Summary:
Terminology matters
simple formulae can take us a long way
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Summary
Stop! Write down two things you remember from this lecture.
My Summary:
Terminology matters
simple formulae can take us a long way
macro structure and micro structures interact to fulfil needs of
system, rather than individual participants.
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Tomorrow
The stock market from a physicist’s point of view. See Notes.
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