Introduction to the Economics of Financial Markets This page intentionally left blank Introduction to the Economics of Financial Markets James Bradfield 2007 Oxford University Press, Inc., publishes works that further Oxford University’s objective of excellence in research, scholarship, and education Oxford New York Auckland Cape Town Dar es Salaam Hong Kong Karachi Kuala Lumpur Madrid Melbourne Mexico City Nairobi New Delhi Shanghai Taipei Toronto With offices in Argentina Austria Brazil Chile Czech Republic France Greece Guatemala Hungary Italy Japan Poland Portugal Singapore South Korea Switzerland Thailand Turkey Ukraine Vietnam Copyright © 2007 by Oxford University Press Published by Oxford University Press, Inc 198 Madison Avenue, New York, New York 10016 www.oup.com Oxford is a registered trademark of Oxford University Press All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior permission of Oxford University Press Library of Congress Cataloging-in-Publication Data Bradfield, James Introduction to the economics of financial markets / James Bradfield p cm Includes bibliographical references and index ISBN-13 978-0-19-531063-4 ISBN 0-19-531063-2 Finance Capital market I Title HG173.B67 2007 332—dc22 2006011610 Printed in the United State of America on acid-free paper To my wife, Alice, to our children, and to their children To the memory of Professor Edward Zabel, a friend and mentor, who taught me the importance of extracting the economic interpretations from the mathematics, and who taught me much more This page intentionally left blank Acknowledgments My greatest debt is to my wife, Alice, whose encouragement, understanding, and clear thinking about choices are indefatigable Most professors owe much to their students; I am no exception I have learned much from the students who have taken the courses from which I have drawn this book Several of those students read many drafts of the book, eliminated errors, and made valuable suggestions for additional examples and for clarity of exposition I thank John Balio, Tierney Boisvert, Katherine E Brogan, Matt Clausen, Mike Coffey, Kaitie Donovan, Matt Drescher, John Durland, Schuyler Gellatly, Young Han, Tom Heacock, Jason Hong, Danielle Levine, Brendan Mahoney, Abhishek Maity, Katie Nedrow, Quang Nguyen, Greg Noel, Cy Philbrick, Brad Polan, Eric Reile, Dan Rubin, Katie Sarris, Kevin St John, Gregory Scott, Joseph P H Sullivan, and Kimberly Walker I appreciate the work of Rachael Arnold, who used her skills as a graphic artist to create computerized drawings of the several figures I thank Dawn Woodward for the numerous times that she assisted me with the arcana of word processing, and for many other instances of secretarial assistance Five former students served (seriatim) as editorial and research assistants I am grateful to Mo Berkowitz, Jon Farber, Gregory H Jaske, Kathleen McGrory, and Mac Weiss for their industriousness, their intelligence, and their constant good cheer Each of them contributed significantly to this book I extend appreciation especially to Dr Janette S Albrecht, who watched the progress of this book through periods of turbulence, and who added several dimensions to my understanding of sunk costs Mrs Ann Burns, a friend of long standing from my days in the dean’s office, cheerfully, speedily, and accurately typed numerous drafts of the manuscript, many of which I wrote by hand, with labyrinthian notes (in multiple colors) in the margins and on the back sides of preceding and succeeding pages I wish Ann and her family well I thank Mike Mercier for his editorial encouragement and guidance during an earlier incarnation of this book My friend and colleague, Professor of English George H Bahlke, who is an expert on twentieth-century British literature, helped me to maintain a greater measure of equanimity than I would have had without his support I am also indebted to my friend and colleague, Professor of History Robert L Paquette, who has written extensively on the Atlantic slave trade, and with whom viii Acknowledgments I teach a seminar on property rights and the rise of the modern state Among other valuable lessons, Professor Paquette reminded me on several occasions that the application of theoretical models in economics is limited by the prejudices of the persons whose behavior we are trying to explain I appreciate the confidence that Terry Vaughn, Executive Editor at Oxford University Press, expressed in my work, which culminated in this book Catherine Rae, the assistant to Mr Vaughn, helped me in numerous ways as I responded to referees’ suggestions and prepared the manuscript Stephania Attia, the Production Editor for this book, supervised the compositing closely, and I thank her for doing so I also appreciate the attention to detail provided by Jean Blackburn of Bytheway Publishing Services Judith Kip, a professional indexer, contributed significantly by constructing the index Preface This book is an introductory exposition of the way in which economists analyze how, and how well, financial markets organize the intertemporal allocation of scarce resources The central theme is that the function of a system of financial markets is to enable consumers, investors, and managers of firms to effect mutually beneficial intertemporal exchanges I use the standard concept of economic efficiency (Pareto optimality) to assess the efficacy of the financial markets I present an intuitive development of the primary theoretical and empirical models that economists use to analyze financial markets I then use these models to discuss implications for public policy The book presents the economics of financial markets; it is not a text in corporate finance, managerial finance, or investments in the usual senses of those terms The relationship between a course for which this book is written, and courses in corporate finance and investments, is analogous to the relationship between a standard course in microeconomics and a course in managerial economics I emphasize concrete, intuitive interpretations of the economic analysis My objective is to enable students to recognize how the theoretical and empirical results that economists have established for financial markets are built on the central economic principles of equilibrium in competitive markets, opportunity costs, diversification, arbitrage, and trade-offs between risk and expected return I develop carefully the logic that supports and organizes these results, leaving the derivation of rigorous proofs from first principles to advanced texts (Some proofs and technical extensions are presented in appendices to some of the chapters.) Students who use this text will acquire an understanding of the economics of financial markets that will enable them to read with some sophistication articles in the public press about financial markets and about public policy toward those markets Dedicated readers will be able to understand the central issues and the results (if not the technical methods) in the scholarly literature I address the book primarily to undergraduate students The selection and presentation of topics reflect the author’s long experience teaching in the Department of Economics at Hamilton College Undergraduate and beginning graduate students in programs of business administration who want an understanding of how economists assess financial markets against the criteria of allocative and informational efficiency will also find this book useful Bibliography of Nobel Laureates 2001 475 George A Akerlof, A Michael Spence, Joseph E Stiglitz For their analyses of markets with asymmetric information Akerlof, George “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism.” Quarterly Journal of Economics (August 1970) —— An Economic Theorist’s Book of Tales Cambridge, U.K.: Cambridge University Press, 1984 —— “Gift Exchange and Efficiency Wage Theory: Four Views.” American Economic Review (May 1984) —— “Introduction.” In Efficiency Wage Theories of the Labor Market, George A Akerlof and Janet Yellen, eds Cambridge, U.K.: Cambridge University Press, 1986 Akerlof, George, and Janet Yellen “The Fair Wage-Effort Hypothesis and Unemployment.” Quarterly Journal of Economics (May 1990) Spence, Michael, and Richard Zeckhauser “Insurance, Information, and Individual Action.” American Economic Review 61, no (1971): 380–387 Spence, Michael “Job Market Signaling.” The Quarterly Jounal of Economics 87, no (1973): 355–374 —— “Informational Aspects of Market Structure: An Introduction.” The Quarterly Journal of Economics 90, no (1976): 591–597 —— “Investment, Strategy, and Growth in a New Market.” Bell Journal of Economics (1979) —— “Competition, Entry, and Antitrust Policy, Strategy, Predation, and Antitrust Analysis,” Federal Trade Commission (September 1981) —— Competitive Structure in Investment Banking Cambridge, Mass.: Harvard University Press, 1983 —— “Signaling in Retrospect and the Informational Structure of Markets.” American Economic Review 92, no (2002): 434–459 Stiglitz, Joseph “Modigliani, the Modigliani-Miller Theorem, and Macroeconomics.” Paper presented to a conference, “Franco Modigliani and the Keynesian Legacy.” New School University, New York, N.Y., April 14–15, 2005 —— “Information and the Change in the Paradigm in Economics.” The American Economist 47 nos and (Fall 2003 and Spring 2004) Also published in Les Prix Nobel, Tore Frangsmyr, ed., 472–540 Stockholm, Sweden: The Nobel Foundation, 2002; and in Revista Asturiana De Economia 25 (December 2002): 95–164 —— “The Contributions of the Economics of Information to Twentieth Century Economics.” Quarterly Journal of Economics 115, no (November 2000): 1441–1478 This page intentionally left blank Bibliography Akerlof, George A “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism.” Quarterly Journal of Economics (March 1984): 488–500 Alchian, Armen A., and William R Allen Exchange and Production: Competition, Coordination, and Control, 3rd ed Belmont, Calif.: Wadsworth, 1983 Alchian, Armen A., and Harold Demsetz “The Property Rights Paradigm.” Journal of Economic History 33 (1973): 16–27 Arrow, Kenneth J., declaration of, U.S v Microsoft, January 17, 1995 Barbour, Brad M., and Terrance Odean “Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors.” Journal of Finance 55, no (April 2000): 773–806 Bittlingmayer, George, and Thomas W Hazlett “DOS Kapital: Has Antitrust Action against Microsoft Created Value in the Computer Industry?” Journal of Financial Economics, no 55 (2000): 329–359 Black, Fischer, and Myron Scholes “The Pricing of Options and Corporate Liabilities.” Journal of Political Economy 81, no (1973): 637–659 Brander, J A., and T R Lewis., “Oligopoly and Financial Structure: The Limited Liability Effect.” American Economic Review 76 (1986): 956–970 Brooks, Robert, Sinclair Davidson, and Robert Faff “Sudden Changes in Property Rights: The Case of Australian Native Title.” Journal of Economic Behavior & Organization 52 (2003): 427–442 Chen, N., R Roll, and S Ross “Economic Forces and the Stock Market.” Journal of Business 59, no (1986): 383–403 Ching W K., and M S Lee “A Random Walk on a Circular Path.” International Journal of Mathematical Education in Science and Technology 36, no (2005): 680–683 deBondt, Werner, and Richard Thaler “Does the Stock Market Overreact?” In Advances in Behavioral Finance Edited by Richard H Thaler New York: Russell Sage Foundation, 1993 Demsetz, Harold J “Toward a Theory of Property Rights.” American Economic Review: Papers and Proceedings (1967): 347–359 —— “The Cost of Transacting.” Quarterly Journal of Economics 82, no (1968): 33–53 Duffie, Darrell Futures Markets Englewood Cliffs, N.J.: Prentice Hall, 1989 Ellison, Sara Fisher, and Wallace P Mullin “Gradual Incorporation of Information: Pharmaceutical Stocks and the Evolution of President Clinton’s Health Care Reform.” The Journal of Law and Economics 44 (April 2001): 89–130 Elton, Edwin J., Martin J Gruber, Stephen J Brown, and William N Goetzmann Modern Portfolio Theory and Investment Analysis, 6th ed New York: John Wiley & Sons, 2003 Fama, Eugene F “Efficient Capital Markets: A Review of Theory and Empirical Work.” The Journal of Finance 25, no (1970): 383–417 477 478 Bibliography —— “Efficient Capital Markets: II.” Journal of Finance 46, no (December 1991): 1575–1617 Fama, Eugene F., and Kenneth R French “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Economics (February 1993): 3–56 Fama, Eugene F., and Merton H Miller The Theory of Finance New York: Holt, Rinehart and Winston, 1972 “The Force of an Idea.” The New Yorker, January 12, 1998 Harris, Larry Trading and Exchanges: Market Microstructure for Practitioners New York: Oxford University Press, 2002 Hilsenrath, Jon E “Stock Characters: As Two Economists Debate Markets Mr Thaler Takes on Mr Fama.” The Wall Street Journal, Monday, October 18, 2004, A1 Hu, Jie, and Thomas H Hoe “The Insider Trading Debate.” Federal Reserve Bank of Atlanta Economic Review (Fourth Quarter 1997) Hull, John C Options, Futures, and Other Derivatives, 6th ed Englewood Cliffs, N.J.: Prentice Hall, 2006 Jaffe, Jeffrey “Special Information and Insider Trading.” Journal of Business 47, no (July 1974): 410 Jensen, Michael C “Don’t Freeze the Arbs Out.” The Wall Street Journal, December 3, 1986, editorial page —— “Risk, the Pricing of Capital Assets, and the Evaluation of Investment Portfolios.” Journal of Business 42, no (1969): 167 Jensen, Michael C., and William H Meckling “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure.” Journal of Financial Economics (October 1976): 305–360 Keown, Arthur, and John M Pinkerton “Merger Announcements and Insider Trading Activity: An Empirical Investigation.” Journal of Finance 36, no (September 1981): 855–869 Landsburg, Steven E “Random Walks and Stock Prices.” In The Armchair Economist: Economics and Everyday Life, 188–196 New York: The Free Press, 1993 “The Legend of Arthur.” Slate Magazine, January 14, 1998 Leland, Hayne E “Insider Trading: Should it be Prohibited?” The Journal of Political Economy, no 100 (1992): 859 Lintner, John “The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets.” The Journal of Economics and Statistics 47 (1965): 13–37 MacKinley, Craig A “Event Studies in Economics and Finance.” The Journal of Economic Literature 35 (March 1997): 13–39 Maksimovic, V “Capital Structure in Repeated Oligopolies.” The Rand Journal of Economics 19 (1988): 389–407 Maksimovic, V., and S Titman “Financial Policy and a Firm’s Reputation for Product Quality,” The Review of Financial Studies 4, no (1991): 175–200 Malkiel, Burton G A Random Walk Down Wall Street, 8th ed New York: W.W Norton, 2004 Manne, Henry Insider Trading and the Stock Market New York: The Free Press, 1966 Markowitz, Harry Portfolio Selection: Efficient Diversification of Investments New York: John Wiley & Sons, 1959 Modigliani, F., and Merton H Miller “The Cost of Capital, Corporate Finance, and the Theory of Corporation Finance.” The American Economic Review 48 (1958): 261–297 Myers, S C., and N Majluf “Corporate Financing and Investment Decisions When Firms Have Information That Investors Do Not.” The Journal of Financial Economics 13 (1984): 187–122 Bibliography 479 Posner, Richard Economic Analysis of the Law, 5th ed New York: Aspen Law and Business, 1998 —— “A Theory of Primitive Society, with Special Reference to Law.” The Journal of Law and Economics 23 (1980): 1–53 Rose, Nancy L “The incidence of Regulatory Rents in the Motor Carrier Industry.” The Rand Journal of Economics 16, no (Autumn 1985): 299–318 Seyhun, Nejat H “The Effectiveness of the Insider-Trading Sanctions.” The Journal of Law and Economics 35 (April 1992) —— “The Information Content of Aggregate Insider Trading.” The Journal of Business 61, no (January 1988): 1–24 —— “Insiders’ Profits, Costs of Trading, and Market Efficiency.” The Journal of Financial Economics 16, no (1986): 189–212 —— Investment Intelligence from Insider Trading Cambridge: MIT Press, 1998 —— “Why Does Aggregate Insider Trading Predict Future Stock Returns?” The Quarterly Journal of Economics 107, no (November 1992): 1303 Seyhun, Nejat H., and Michael Bradley “Corporate Bankruptcy and Insider Trading.” The Journal of Business 70, no (1997): 189–216 Sharpe, William F “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk.” The Journal of Finance 19 (1964): 425–442 Shiller, Robert J Irrational Exuberance, 2nd ed Princeton, N.J.: Princeton University Press, 2005 —— “The Volatility of Long-Term Interest Rates and Expectations Models of the Term Structure.” The Journal of Political Economy, no 81 (1979): 1190–1219 Siegel, Jeremy J Stocks for the Long Run: The Definitive Guide to Financial Market Returns and Long-Term Investment Strategies New York: McGraw-Hill, 2002 “Soft Microeconomics: The Squishy Case against You-Know-Who.” Slate Magazine, April 23, 1998 “The Stock Market’s Verdict of Microsoft’s Antitrust Case.” Economic Intuition (Spring 2000): 1–2 Stoll, Hans R., and R E Whaley Futures and Options: Theory and Applications Belmont, Calif.: South-Western Publishing Company, 1993 Summers, Lawrence H “Does the Stock Market Rationally Reflect Fundamental Values?” The Journal of Finance, no 41 (1986): 591–601 Thaler, Richard H Advances in Behavioral Finance New York: Russell Sage Foundation, 1993 Titman, Sheridan “The Effect of Capital Structure on a Firm’s Liquidation Decision.” The Journal of Financial Economics 13 (1984): 137–151 Weisbrod, Burton A “The Health Care Quadrilemma: An Essay on Technological Change, Insurance, Quality of Care, and Cost Containment.” The Journal of Economic Literature no 523 (1991) This page intentionally left blank Index Agency, problem of, 11–12 capital structure and, 441, 444–45 asset substitution, 316, 330–36 enforcing payouts of free cash, 321–23, 355n10 using debt to resolve, 323–30 corporate takeovers and, 434–35 financial markets and economic efficiency, 36–38 insider trading and, 361–63 Akerloff, George, 29, 337 See also Lemons model Alienability, 305 Allocation of resources economic efficiency and, financial markets and, 167–68 trade-offs of, 3–5 Antitrust action, event study of effect of, 300–302 Approximation, confidence and, 137–38 Arbitrage equilibrium and perfect positive/negative correlation, 196–99 put-call parity and, 396–97 Arbitrage pricing theory, 236–37, 246–49 Asked price See Bid-asked spread Asset pricing models, 295 See also Capital asset pricing model; Multifactor pricing models Assets, value of, 98–99, 135, 232n3 Asset substitution, problem of, 13–14 capital structure and, 316, 330–36 Assumptions, used in economics, 215–16 Asymmetric information, problem of, 12–13 capital structure and, 336–47, 441, 443–44 corporate takeovers and, 435 economic efficiency and financial markets, 29–36 insider trading and, 363–68 signaling with dividends and, 436, 438–39 Australian property rights, event study of effect of change in, 305–7 Banks See also Interest rates financing new projects by borrowing from, 103 flow of interest and, 102 Barber, Brad M., 278–79 Behavioral finance, 274, 432–33, 437 Bid-asked spread efficient markets hypothesis and, 281–84 insider trading and, 369–72 Bittlingmayer, George, 300–302 Black, Fischer, 189, 377 See also Black-Scholes option pricing formula Black-Scholes option pricing formula, 377, 391–94, 410 contrasted to simple model, 391–92 implicit options and, 403–5 Bonds See also Capital structure callable, defined, 23–24 changes in price of, 253n6, 290n8 as contractual claims, 7, 42n6, 316 convertible, defined, 24–25 coupon rate and, 126n3 defaults on, 20, 203–4, 253n8 defined and explained, 19–21 five-factor asset pricing model and, 236, 245–46 government, and reward for waiting, 111–12, 114, 126n1 481 482 Index Bonds (continued) implicit options and value of leveraged firm, 400–405, 410 literature on, 431, 437 in modern portfolio theory, 120–23 places for trading, 26 Book equity, in asset pricing theory, 242–45, 249 Brander, J A., 349 Brooks, Robert, 305–7 Bubbles, 264–65, 271–74 Budget line, intertemporal, 69–75 efficient level of investment and, 85–91 indifference curves and maximizing utility, 80–82, 100 mutually beneficial exchanges and, 82–85 Callable, convertible bonds, 23–24, 343–47 Call options Black-Scholes formula for pricing, 391–94 defined and explained, 25–26, 378–81 simple model of equilibrium price of, 381–91 Call price, of bond, 23 Capital asset pricing model (CAPM), 201–34, 442–43 capital market line, 208–10, 231 derivation of, 215–21 characteristic lines, 156, 212–14 compared and contrasted to multifactor pricing models, 203–5, 235–37 equilibrium defined with, 266–67, 296–97 introduced, 41, 158, 201–5, 214 microeconomic foundations of, 206–7 portfolio theory and, 167–68, 205 security market line, 211–12, 231 derivation of, 221–30 three equations of, introduced, 207–8 three-factor model contrasted to, 203–4 Capital gains/losses, 98–100, 106, 133–35 Capital goods, accumulated stock of consumption goods as, 17n2, 48, 49 transfer of consumption in time and, 50–51 Capitalized value of future payments, economic equivalence and, 64–66 Capital market line, in capital asset pricing model, 208–10, 215–21, 231 Capital market theory, 114, 157 Capital structure, 313–55, 441 asset substitution and, 316, 330–36 debt analysis and, 313–14 defined, 314–16 duopoly and, 348–49, 354n3 economic significance of, 316–18 effect on reputation for quality product, 349–51 mutually beneficial exchanges between investors with different tolerances for risk and, 318–21 problem of agency and, 441, 444–45 asset substitution, 316, 330–36 enforcing payouts of free cash, 321–23, 355n10 using debt to resolve, 323–30 problem of asymmetrical information and, 336–47, 441, 443–44 signaling with dividends, 436, 438–39 Characteristic lines, in capital asset pricing model, 156, 212–14 Chicago Board of Trade, 416 Clearinghouse, for futures market, 416, 420–21 Coase, Ronald, 306 Common stock See also Capital structure defined, 21–23 financing new projects by issuing new shares of, 103–7 implicit options and value of leveraged firm, 400–405, 410 in modern portfolio theory example, 121–24 places for trading, 26 as residual claim, 7, 316 utility and value of single share, 94–100 Comparative advantage futures contracts and, 417–18 trade based on, 51–54 Compounding, continuous and periodic, 410–11 Confidence, approximation and, 137–38 Constant utility curves See Indifference curves Consumption defined, intertemporal budget line and, 69–75 transferring from future to present, 50–51 transferring from present to future, 49–50 Index Consumption goods, 17n2, 48, 49 Continuous compounding of interest, 410–11 Contractual claims See Bonds Convertible bonds, 24–25, 343–47 “Corporate Financing and Investment Decisions When Firms Have Information That Investors Do Not” (Myers and Majluf), 29 Corporate takeovers, 434–36, 438 Correlation coefficient, 145–46, 158–60 portfolio theory and, 172–88, 189–97 Cost of capital efficient markets hypothesis and, 279–84 insider trading and, 368–72 Coupon rate, of bond, 126n3 Cournot duopoly, 354n3 Covariance, on two discrete random variables, 145–46 Davidson, Sinclair, 305–7 Deadweight loss defined, 17n5 insider trading and, 365–66 deBondt, Werner, 274–75, 433 Debt See Bonds; Capital structure Debt-to-equity ratio, problem of agency and, 323–30 Default, on bonds, 20, 203–4, 253n8 Demsetz, Harold, 43n11, 282, 306 Deregulation, event study of effect of, 302–4 Derivatives, 433–34, 438, 445 See also Futures contracts; Options Diversification problem of agency and, 12, 37–38 risk and, 115, 126n5, 157, 163n19 Dividends, 22 signaling with, 436, 438–39 Duopoly, capital structure and, 348–49, 354n3 Economic efficiency defined, financial markets and financial securities, 19–26 fundamental principles summarized, 111 informational efficiency, 38–41 liquidity, 26–29 problem of agency, 36–38 problem of asymmetrical information, 29–36 483 transaction costs, 26 mutually beneficial exchanges and, 8–11 Economic equivalence budget line and, 70–72 present value and, 64–66 Economic rent, 302–3 Economics of financial markets, 47–67 microeconomics and capital asset pricing model, 206–7 use of assumptions in, 215–16 Efficiency See Economic efficiency; Information Efficient markets hypothesis, 257–93, 442, 443 defined, 39, 257–58 equilibrium, stability, volatility distinguished, 284–86 forms of, 258–60 informational efficiency and, 39–41 examples of, bubbles or rational variations, 271–74 examples of, residuals and, 265–71 predictability of returns and, 274–76 rationality and joint hypothesis and, 261–65 speed of adjustment to private information, 277–79 speed of adjustment to public information, 276 information trading, liquidity trading and cost of capital, 279–84 random walks and, 260, 290n7 significance for economic efficiency, 261 unit tax effect and, 261–62, 280–81, 287–89 Ellison, Sara Fisher, 307–8 Equilibrium arbitrage and perfect positive/negative correlation, 196–99 average rate of return and, 116–17 defined, 9, 441 efficient markets hypothesis and, 285 price of good and, 98 price of options and, 379–80, 390–91 price of securities and, 121–24, 131–32 separating and pooled, 343–47 Equity, book and market value in asset pricing theory, 242–45, 249 484 Index Event studies, 276, 295–310 corporate takeovers and, 435 examples of, 300 antitrust action against Microsoft, 300–302 Australian property rights changes, 305–7 merger announcements and insider trading, 304–5 pharmaceutical stocks and incorporation of information about proposed health care changes, 307–8 regulatory rents in motor carrier industry, 302–4 risk-adjusted residuals and price adjustment to new information, 295–97 structure of, 297–300 Ex dividend, 133, 110n2 Exercise (strike) price, of option, 378–80 Expected value of random variable, 141–46, 162n12 Expected value of rate of return, effect of price on, 146–49 Expiration date, of option, 378, 379 Factor analysis, 246–48 Faff, Robert, 305–7 Fama, Eugene, 236, 278, 287 See also Efficient markets hypothesis; Five-factor asset pricing model; Three-factor asset pricing model Financial markets allocation of resources by, 167–68 economic efficiency and financial securities, 19–26 informational efficiency, 38–41 liquidity, 26–29 problem of agency, 36–38 problem of asymmetric information, 29–36 transaction costs, 26 economics of, 47–67 fundamental principles summarized, 111 income and wealth distinguished, 59 income, wealth, and present values, 60–66 primitive economy with no trading, 47–51 primitive economy with trading, but no markets, 51–57 rise of markets, 57 Financial securities See also Bonds; Common stock; Futures contracts; Options defined, 4–5, 59, 441 definition of risk for, 112 importance of informational efficiency to, 91–92 Financing choices See also Capital structure with future payments certain, 90–91 utility and profitable investment projects, 102–9 Firms rationale of abstracting from, 58 value of, 43n14 Firm-specific (idiosyncratic) risk, in modern portfolio theory, 114–15, 126n6 Fisher diagram for intertemporal allocation, 69–92 allocating wealth to maximize utility, 80–82 budget line, 69–75 choice of financing, 90–91 efficient level of investment, 85–91 indifference curves, 75–80 informational efficiency’s importance and, 91–92 mutually beneficial exchanges, 82–85 Five-factor asset pricing model, 236, 245–46, 249 Flows contrasted to stocks, 48–49 income as flow of value, 59 Forward contract, 415–16 Free cash flow defined, 322 enforced payout of, 321–23, 355n10 French, Kenneth, 236 See also Five-factor asset pricing model; Three-factor asset pricing model “Fully reflects,” definition and implications, 257–58 Fundamental (intrinsic) value of prices, 263 Future price, defined, 419 Futures contracts, 415–29, 446 efficient allocation of risk and, 417–18 as financial securities, 416–17, 420–22 futures prices, spot price, future price, 418–19 Index information on spot prices and, 422–23, 427 investment, speculation, hedging and, 423–28 long and short sides of, 419–20 as standardized forward contract, 415–16 Futures price, defined, 418–19 Hazlett, Thomas, 300–302 Health care reforms, event study of proposed changes on pharmaceutical stocks, 307–8 Hedging, 426–28 Homemade dividends, 97 Homemade options, 397–99 Hostile takeover, 17n9 Hu, Jie, 357, 358, 360, 372, 373–74 Implicit options, 446 explained, 378, 399–400 in leveraged firm, 400–405, 410 on postponable, irreversible investment, 405–9, 410 Income distinguished from wealth, 59 wealth, present value, and, 60–66 Indifference curves, 75–76 budget line and maximizing utility, 80–82, 100 efficient level of investment and, 85–91 marginal rate of substitution and, 78–80 mutually beneficial exchanges and, 82–85 postulates that govern, 77–78 Information See also Efficient markets hypothesis financial markets and efficient, 38–41, 91–92, 442 “new,” 106 trading of bid-asked spread and, 283–84 defined, 283 liquidity trading, cost of capital, and, 279–84 value to option of collecting, 399–400, 405–9 Informed investors (market professionals/ speculators), 357–58, 372 Initial public offerings, 431–32, 437 Inside information, defined, 359 See also Insider trading Insider, defined, 358–59 485 Insider trading, 357–75 definitions, 358–59 effects of, 360–61 on cost of capital through effect on liquidity, 368–72 on merger announcements, event study, 304–5 on mitigating problems of agency, 361–63 on protecting value of confidential information, 363–68 on trade-off between insiders and informed investors in producing informative prices, 372–73 efficient markets hypothesis and, 277–78 owners of inside information, 359–60 public policy and, 357–58, 373–74, 446–47 Interest rates continuous and periodic compounding of, 410–11 equilibrium value for security and, 122–24 factor for TERM structure of, 245–46 mutually beneficial exchanges and, 82–85 utility and prospective investments, 85–91 utility and single share value, 94–100 Intertemporal allocation economics of, 47–67 income and wealth distinguished, 59 income, wealth, and present values, 60–66 primitive economy with no trading, 47–51 primitive economy with trading, but no markets, 51–57 rise of markets, 57 Fisher diagram for, 69–92 allocating wealth to maximize utility, 80–82 budget line, 69–75 choice of financing, 90–91 efficient level of investment, 85–91 indifference curves, 75–80 informational efficiency’s importance, 91–92 mutually beneficial exchanges, 82–85 Intertemporal exchange, defined, 16n1 Investment defined, 423–24 indifference curves and efficient level of, 85–91 486 Index Investment projects See also Capital structure implicit options and postponable, irreversible, 405–9, 410 profitable project defined, 43n14 utility, profitable projects, and financing, 100–109 utility and value of single share, 94–100 Investors, asset pricing and competition among, 239–40 Isotonic regression, 307, 310n35 Jaffe, Jeffry, 277 Jensen, Michael, 279, 424 Joint hypothesis, 40–41, 286 equilibrium value of prices and, 261–65 risk-adjusted residuals and, 298 Keown, Arthur, 304–5 Law of large numbers, 137–38, 162n10 Lemons model, 29–31, 337–38 inefficient resource allocation and, 31–36 insider trading and, 363–65 Lender in due course, 21 Lewis, T R., 349 Linear model of rate of return, 150–56 Lintner, John, 201, 230 Liquidity, 26–29 bid-asked spread and, 281–84 effect of insider trading on cost of capital through effect on, 368–72 Liquidity trading, 358 bid-asked spread and information trading, 283–84 defined, 283 information trading and cost of capital, 279–84 MacKinley, A C., 298 Majluf, Nicholas, 29 Maksimovic, V., 350 Manne, Henry, 361 Margin, futures contracts and, 416–17 Marginal rates of substitution, 54–57, 67n3, 78–80, 86–91 Market equity, in asset pricing theory, 242–45, 249 Market failures/imperfections See Agency; Asset substitution; Asymmetric information “Market for ‘Lemons’” (Akerloff), 29 See also Lemons model Market microstructure, 433, 438 Market portfolio, capital asset pricing model and, 206–7, 221–31 Market price of option, 379–80, 381, 400, 413n4 Market price of risk, 115–18, 201–2, 234n14 capital market line and, 209–10 security market line and, 211–12 two-factor asset pricing model, 238–41 Marking to the market, 416, 421–23 Markowitz, Harry, 201, 230 Material information, defined, 12, 359 See also Asymmetric information; Insider trading Mergers capital structure and, 319–21 event study of effect of announcements of, 304–5 Microsoft, event study of effect of antitrust action against, 300–302 Miller, Merton, 317 Modern portfolio theory (MPT), 113–17, 445 model with uncertain future earnings, 118–22 primary questions answered by, 112, 113–14 reward for bearing risk, 111, 114–17 reward for waiting, 111–12, 114, 126n1 Modigliani, Franco, 317 Monopolies, 300–301, 303 “More is better than less” postulate, 77 Mortgage-backed security, 21 Mortgaged loan, 21, 23–24 Motor carrier industry, event study of effect of deregulation on, 302–4 Mullin, Wallace P., 307–8 Multifactor pricing models, 235–53, 443 arbitrage pricing theory, 237, 246–49 compared and contrasted to capital asset pricing model, 203–5, 235–37 two-factor, 237–41, 249–51 three-factor, 236, 241–45, 249 five-factor, 236, 245–46, 249 Mutual funds, 279, 291n27, 432, 437 Mutually beneficial exchanges, 5–8 economic efficiency and, 8–11 optimal intertemporal allocation and, 82–85 Myers, Stewart C., 29 Index Net earnings, 107 “New” information, 106 Noe, Thomas H., 357, 358, 360, 372, 373–74 Nominal default, on bond, 253n8 Odean, Terrance, 278–79 Opportunity costs, 48 financing options and profitable investments, 101–9 Options, 377–414, 445–46 Black-Scholes option pricing formula, 377, 391–94, 403–5, 410 call options explained, 378–81 homemade options, 397–99 implicit options explained, 399–400 in leveraged firm, 400–405, 410 on postponable, irreversible investment, 405–9, 410 market price of, 379–80, 381, 400, 413n4 places for trading, 26 put-call parity, 394–97 put options explained, 381 simple model of equilibrium price of call option, 381–91 contrasted to Black-Scholes, 391–92 writers of, 380–81 Parameter, in probability models, 140–41 Pension funds, efficient markets hypothesis and, 279 Percentage/percentage points, 127n7 Pharmaceutical stock, event study of effect of proposed health care reforms on, 307–8 Pinkerton, John M., 304–5 Poison pill, 17n10 Pooled equilibrium, 343 Portfolio managers, efficient markets hypothesis and, 279 Portfolio theory, 37, 167–200, 230 capital asset pricing model and, 167–68, 205 perfect positive and negative correlation and, 189–97 portfolios as synthetic securities, 169–70 risky securities and, 170–72 trade-offs between expected return and standard deviation, 172–88, 197–98 used in economics of financial markets, 167–68 487 Posner, Richard, 306 Postulates (first principles), in capital asset pricing model, 236, 252n1 “Predictable immediacy,” 27, 43n11 Prediction, correlation and, 159–60 Preferred stock, 42n6 Premium, on call option, 25 Present value, 60–66, 124 profitable investments and, 100–102 Price of securities See also Capital asset pricing model; Multifactor pricing model adjustment to new information, 265–74 bid-asked spread and insider trading, 369–72 effect on expected rate of return, 132–36, 146–50 equilibrium configuration of, 131–32 fundamental (intrinsic) value of, 263 informational content of, 361 insider trading and speculators, 372–73 rates of return and, 132–36 rational movement of, 263–64 steps in predicting, 391 Private information, speed of adjustment to, 277–79 Probabilistic models, 131–63 ␤ parameter as quantity of risk, 157–58 correlation and prediction, 158–60 effect of price on expected rate of return, 146–49 joint probability distribution for two discrete random variables, 142–46 linear model of rate of return, 150–56 normal probability distributions, 138–42, 146 objectives of using, 131–32 rates of return and prices, 132–36 rates of return as random variables, 136–38 Probability density function, 138–41, 146 expected value and standard deviation, 141–42 portfolio theory and, 169–72, 173, 182–97 two-factor asset pricing model, 237–41 Production possibility frontier, 71 Professional portfolio management, efficient markets hypothesis and, 279 Profit, versus utility, 88–90 Property rights, event study of effect of change in, 305–7 488 Index Public information, speed of price adjustment to, 276 Public policy issues, 14, 168, 446 insider trading and, 357–58, 373–74, 446–47 Purchasing power default, on bond, 253n8 Put-call parity, 378, 394–97 Put options, 381 Quality of product, capital structure and reputation for, 349–51 Quantities of risk, 115, 157–58 capital asset pricing model and, 202, 203 two-factor asset pricing model, 237–41 Random variable, 131–32 expected value and, 141–42, 162n12 rates of return as, 136–38, 146 Random walks, 260, 290n7 Rate of return in capital asset pricing model capital market line and, 208–10, 215–21 security market line and, 211–12, 221–30 economics of substitution and, 319–21 efficient markets hypothesis and, 265–71, 273–74 expected value and price, 146–49 linear model of, 150–56 in portfolio theory, 169–72 perfect positive/negative correlation, 189–97 trade-offs, 172–88, 197–98 price of securities and, 132–36, 146–50 as random variables, 136–38, 146 size of firm and informational efficiency, 271–76 utility and prospective investments, 86–91 Rationality efficient markets hypothesis and, 278 joint hypothesis and informational efficiency, 261–65 predictability of returns and, 271–74 price changes and informational efficiency, 263–64 Real options, 25 Regression lines, 154–56 Regulatory rents, event study of effect on motor carrier industry, 302–4 Reputation, for quality of durable product, 349–51 Residual claims See Common stock Retained earnings, financing new projects with, 107–8 Rewardable risk See Systematic risk Risk See also Market price of risk; Modern portfolio theory; Quantities of risk asset pricing and sources of, 203–4 aversion to, 112–13 ␤ parameter as quantity of, 157–58 defined for financial security, 112 expected future return and, 4–5, 7–8, 12, 42nn2–4 inside information and managers’ incentives to take, 362–63 reward for bearing, 111, 114–17 two kinds of, 114–17 Risk-adjusted residuals, 295, 442 efficient markets hypothesis and, 265–74 Risk-free assets capital market line and, 218–21 contractual claims as, 316 Riskless portfolios analytical significance of, 189–91 perfect positive/negative correlation, 189 with two risky securities with perfect negative correlation, 191–94 with two risky securities with perfect positive correlation, 194–97 Riskless security, defined, 170 Risky security, defined, 170 Rose, Nancy, 302–4 Saleability of rights, economic significance of, 22–23 Scholes, Myron, 189, 377 See also Black-Scholes option pricing formula Securities See Financial securities; Price of securities Security analysts, efficient markets hypothesis and, 278–79 Security market line, in capital asset pricing model, 211–12, 221–30, 231 Security market plane for three-factor asset pricing model, 244 for five-factor asset pricing model, 246 Separating equilibrium, 343–47 Seyhun, N Nejat, 278 Sharpe, William, 201, 230 Sherman Antitrust Act of 1840, 300–302 Shiller, R J., 275 Short positions inside information and, 362, 365 portfolio theory and, 171–72, 178–79, 181, 186–87, 194–97 489 Index Signaling with dividends, 436, 438–39 Size factor, in asset pricing theory, 203, 241–42, 244–45, 271–74 Speculators defined, 276 futures contracts and, 417–18, 423–28 insider trading and, 372–73 stability and, 285 use of Black-Scholes formula, 393 S&P 500, risk measurement and, 116 Spot price defined, 419 information about future values and, 422–23, 427 long and short sides and, 419–20 Spread See Bid-asked spread Stability, efficient markets hypothesis and, 285–86 Standard deviation, 141–46, 162n12 in capital asset pricing model capital market line and, 208–10, 215–21 security market line and, 211–12, 221–30 defined, 141, 144, 162n13 in portfolio theory, 169–72 perfect positive/negative correlation, 189–97 trade-offs, 172–88, 197–98 rate of return and, 148–50 for two discrete variables, 142–46 Stock See Common stock; Preferred stock Stocks capital goods as, 49 contrasted to flows, 48–49 wealth as stock of value, 59 Substitution economics of, 318–21, 354–55n5 marginal rates of, 54–57, 67n3, 78–80, 86–91 Summers, L H., 275 Supermajority provision, 17n10 Systematic risk, 114–18, 125 internationally diversified portfolio and, 126n5 in linear models of rate of return, 151–53 reward for bearing, 115–16 Takeovers, corporate, 434–36, 438 Tangency condition, security market line and, 222–29 Tax (unit) effect, efficient markets hypothesis and, 261–62, 280–81, 287–89 Thaler, Richard, 274–75, 433 Three-factor asset pricing model, 203–4, 236, 241–45, 249 Titman, Sheridan, 350–51 “Trading is Hazardous to Your Wealth” (Barber and Odean), 279 Transaction costs, defined, 26 Two-factor asset pricing model, 237–41, 249–51 Uncertain outcome models, 111–27 equilibrium bond and stock price and, 122–24 modern portfolio theory and, 113–18 risk and risk aversion and, 112–13 Underlying security, of option, 378, 379–80, 413n4 Unit tax effect, efficient markets hypothesis and, 261–62, 280–81, 287–89 Unrewardable (firm-specific) risk, 114–15, 126n6 Utility efficient level of investment and, 86–91 maximizing in firm with many shareholders, 93–110 capital gains and losses and, 98–100 profitable investments projects and, 100–109 single share value and, 94–100 versus profit, 88–90 Value, inside information and manager’s incentives to create, 361–63 See also Agency Value of firm, 43n14 Value Line Investment Survey, 278 Variables, in probability models, 140–41 Variation margin, futures contracts and, 416–17 Volatility, efficient markets hypothesis and, 285–86 Waiting, reward for, 111–12, 114, 126n1 Wealth allocating to maximize utility, 80–82 distinguished from income, 59 income, present value, and, 60–66 Weisbrod, Burton A., 307 “Willing to substitute” postulate, 77 Writer of option, 380–81 Zero coupon bond, 126n3 ... proportion of the firm they must acquire if they are to recover their investment The larger the amount by which the new project will increase the value of the firm, the smaller the proportion of the. . .Introduction to the Economics of Financial Markets This page intentionally left blank Introduction to the Economics of Financial Markets James Bradfield 2007 Oxford University... Equations of the CAPM A Summary of the Intuitive Introduction to the CAPM The Derivation of the Capital Market Line The Derivation of the Security Market Line Interpreting ␤i as the Marginal Effect of