Chapter 1
Markets and Players
Investments
© K. Cuthbertson and D. Nitzsche
The Investment Setting




What Is An Investment
Why Invest?
Pure Rate of Interest
The Effects of Inflation
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What is an Investment?
 Investment

Current commitment of $ for a period of
time in order to derive future payments that
will compensate for:
 Time
the funds are committed
 Expected rate of inflation
 Uncertainty of future flow of funds
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Why Invest?
 By
investing (saving money now instead of
spending it), individuals can tradeoff
present consumption for a larger future
consumption.
 Earning life cycle and utility of smooth
consumption
 Borrowers and lenders
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Pure Rate of Interest

Exchange rate between future
consumption (future dollars) and present
consumption (current dollars)
 Market
forces determine rate
 Example:

If you can exchange $100 today for $104 next
year, this rate is 4% (104/100-1).
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The Effects of Inflation

Inflation
‒
If the future payment will be diminished in value
because of inflation, then the investor will
demand an interest rate higher than the pure
time value of money to also cover the
expected inflation expense.
Copyright © 2010 Nelson Education Ltd.
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Figure 1: Traders
• Arbitrageurs :
Ensure quoted price = ‘fair value’ (risky arbitrage)
Equalize prices of identical securities (riskless arbitrage)
• Hedgers :
Offset risks that they currently face
• Speculators :
Take risky ‘open’ positions to exploit profitable opportunities.
May be based on “fundamentals” -equivalent to ‘risky arbitrage’
May involve ‘rules of thumb’ - noise traders.
© K. Cuthbertson and D. Nitzsche