Econ 14 Files
Econ 14 Lecture
Notes
Lecture 10: Financial Markets
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Economics 14 |
Lecture 10: Financial Markets
nominal and real interest rates
present value
stock markets
what determines the price of a share of stock?
Nominal and Real Interest Rates
| The interest rate is the fee for using money, expressed in annual percentage terms. The interest rate is determined by the supply and demand for money. The demand for money comes from those with a shortage of funds, borrowers or investors. The supply of money comes from those with a surplus of funds, lenders or savers. The interest rate is determined by the equilibrium of money supply and money demand. |  |
Market interest rates are nominal interest rates, interest rates unadjusted for inflation. A nominal interest rate can be divided into two components: the increase in purchasing power the lenders demands for the use of her money (the real interest rate) and the expected rate of inflation. Since inflation reduces the purchasing power of money, lenders will build the expected inflation rate into the interest rate they charge borrowers in order to protect themselves from the loss of purchasing power. So, the nominal interest rate equals the real interest rate plus the expected inflation rate. Real interest rates can actually turn out to be negative. This is like paying someone to borrow your money. Suppose the interest rate you receive on your savings account is 1%. Then, the nominal interest rate is 1%. Inflation is likely to be 2.5% this year, so the real interest rate on your savings account is -1.5%.
Present Value
We want to compare the dollar amounts received at different points of time in the future. The problem is that dollars received in the future are not as valuable as today's dollars. The concept of present value is used to compare dollars amounts received/spent at different points in time.
Present value is the value today of some amount to be received in the future. If I put $100 in the bank and receive 5% interest, I will have $105 in 1 year. So, the present value of $105 to be received in 1 year is $100. $100 now is the same as getting $105 1 year from now because $100 will grow into $105 in a year.
present value $1
of $1 to = -------------
be received n
in n years (1 + i)
where i = interest rate
For example, the present value of $100 to be received next year (with i = 5%) equals ($100)/(1 + 0.05) = ($100)/(1.05) = $95.
The higher the interest rate, the lower the present value of money to be received in the future.
Stock Markets
Shares of ownership in a corporation are bought and sold in stock markets.
kinds of stock markets:
- primary v. secondary
- exchages v. over-the-counter markets
What Determines the Price of a Share of Stock
Owners of a share of stock have two sources of potential profits: (1) dividends and (2) capital gain/loss. These two sources of potential profit for the shareholder depend on the profitability of the business.
The efficient markets hypothesis argues that all available information about a company and its business prospects is reflected in the price of the company's stock.
The incentive to profit from mispricing contributes to making the stock market efficient. Suppose the market price of a share of Harley Davidson stock is $59 but your forecast of Harley's future returns suggests the price should be $80. The demand for Harley Davidson stock will go up, driving the price up until it reaches $80. If you believe that Harley Davidson stock is overvalued, you can profit by selling the stock short. So long as the transactions costs of buying and selling financial instruments are low, traders can profit by eliminating deviations from the price that the available information predicts.
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David A. Latzko Business and Economics Division Pennsylvania State University, York Campus office: 13 Main Classroom Building phone: (717) 771-4115 fax: (717) 771-4062 e-mail: web: www.yk.psu.edu/~dxl31 |
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