(Econ 512): Economics of
Financial Markets
Chapter One:
Asset Markets and Asset Prices
Dr. Reyadh Faras
Econ 512
Dr. Reyadh Faras
1.1 Capital Markets
 Functions of financial systems:
1) Clearing and settling payments
2) Pooling resources and subdividing shares
3) Transferring resources across time and
space
4) Managing risk
5) Providing information
6) Dealing with incentive problems
Econ 512
Dr. Reyadh Faras
 List of Capital Markets:
1) Equity or Stock Markets
2) Bond Markets
3) Money Markets
4) Commodity Markets
5) Physical Asset Markets
6) Foreign Exchange Markets
7) Derivatives Markets:
a) Forward agreements
b) Options
Econ 512
Dr. Reyadh Faras
1.2 Asset Price Determination: An Introduction
1.2.1 A single asset market
 Economic theory of supply and demand of price
determination applies to asset markets.
 Asset prices more flexible than volume of assets
 Market price adjusts so that wealth holders hold
the existing stock.
 In some cases, total stock of existing assets treated
as Zero (volume of purchases equals sales).
 Q: what determines the demand to hold the asset?
 A: a) preferences, b) prices, and c) income
Econ 512
Dr. Reyadh Faras
Figure 1.1: Market Equilibrium for a Single Asset
Econ 512
Dr. Reyadh Faras
1.2.2 Multiple asset markets: a more formal
approach
 Q: What are the forces determining market prices
of different assets?
 Assume many investors with initial wealth, each is
a price taker. Select portfolio according to the
decision rule: number of assets to hold as a
function of observed prices and initial wealth.
 Market equilibrium is defined by a set of asset
prices and an allocation of assets among investors
that satisfy the following conditions.
Econ 512
Dr. Reyadh Faras
1) Each portfolio is determined according to the
decision rule.
2) Demand equals supply
 Some investors are allowed to hold negative
amounts of assets
 The main components of the approach are:
1) At each instant of time total asset stocks are
given.
2) Asset prices adjust so that existing stocks are
willingly held.
3) Asset stocks change with time. Also portfolios
change. As a result, prices change.
Econ 512
Dr. Reyadh Faras
1.2.3 Rates of return
 Assets are held because they yield a rate of return:
Rate of Return ≡ payoff – Price
Price
 An asset’s payoff have several components (e.g.
bonds, deposits, shares)
 Asset’s rate of return between t and t+1 is:
yt+1 ≡ vt+1 – pt
pt
 Rate of return is measured by the proportional
rate of change of the asset’s market value.
 Real rate of return = nominal rate – inflation rate
Econ 512
Dr. Reyadh Faras
1.2.4 The roles of prices and rates of return
 Most important aspect of R.O.R. for decision
making; they forward looking: they depend on
future payoffs (which are partly uncertain).
 Current market prices play two roles in Fin. Econ:
1) The price represents an opportunity cost.
2) The price conveys information.
Econ 512
Dr. Reyadh Faras
1.3 The Role of Expectations
 According to Keynes: asset prices affect
expectations, expectations affect decisions,
decisions affect prices.
 Thus, for a higher price today, investors infer that
the price will be higher tomorrow.
 This leads to greater demand to hold the asset.
 In the presence of such extrapolative expectations,
demand curve could be positively sloping.
 Investors are assumed to “Rational Expectations”:
expectations are formed with awareness of forces
that determine market prices.
Econ 512
Dr. Reyadh Faras
 Fischer Black (1986) introduced the concept
of noise to financial analysis.
 Some investors are assumed to act in
arbitrary ways that are difficult to explain
as the outcome of consistent behavior.
 These investors are called “noise traders”
 “Rational Traders” behave according to
more coherent rules and have better
information than noise traders.
Econ 512
Dr. Reyadh Faras
 The noise-trader approach is part of
behavioral finance which exploits ideas
from outside economics, including
psychology.
 The acquisition and processing of
information by investors received limited
attention in fin. Econ.
 Each investor’s beliefs about assets’ payoffs
are predictions made from the investor’s
personal model of capital markets.
Econ 512
Dr. Reyadh Faras
1.4 Performance Risk, Margins and Shortselling
1.4.1 Performance Risk and Margin Accounts
 Uncertainty about the future plays a central role
in economics and permeates every branch of
financial analysis.
 Price Risk: prospect that mkt. value of an asset
changes by an unknown amount in the future.
 Performance Risk: prospect that a contractual
obligation will not be fulfilled.
 Minimizing performance risk is made via deposits
in margin accounts: contracting parties agree to
deposit funds with a third party.
Econ 512
Dr. Reyadh Faras
Example: buying on margin
Econ 512
Dr. Reyadh Faras
1.4.2 Short-sales
 Selling short: the action of selling an asset that the
investor does not own.
 The asset is borrowed prior to the sale.
 The motive: at a date following the short-sale, the
asset will be purchased for a lower price and
returned to its lender.
 The short-seller then gains the difference between
the sale and purchase prices.
 Exchange authorities place restrictions on the
circumstances in which short-sales are permitted.
 Only restricted group of investors permitted to to
engage in short sales.
Econ 512
Dr. Reyadh Faras
Example: margins with short-sales
Econ 512
Dr. Reyadh Faras
1.5 Arbitrage
1.5.1 The arbitrage principle
 Arbitrage Strategies: patterns of trade motivated
by the prospect of profiting from discrepancies
between the prices of different assets but without
bearing any risk.
 Observed market prices reflect the absence of
arbitrage opportunities.
 With arbitrage, investors could design strategies
that yield unlimited profits with certainty.
 Arbitrage implies the law of one price.
 Financial theories are founded on the absence of
arbitrage opportunities.
Econ 512
Dr. Reyadh Faras
Example 1: foreign exchange markets
Econ 512
Dr. Reyadh Faras
Example 2: a bond market
Econ 512
Dr. Reyadh Faras
1.5.2 Market frictions
 Transaction costs: fees, taxes, trade charges
 Implicit T.C.: difference between bid and ask
prices and time devoted to decision making.
 Institutional restrictions: prohibitions on
particular class of trades or conditions to be
fulfilled before trades are permitted.
 The assumption of frictionless markets underpins
the absence of arbitrage opportunities.
 Frictions do not necessarily impinge equally on all
market participants.
Econ 512
Dr. Reyadh Faras
1.5.3 All sorts of assets
 Components of return (or cost) from holding as
asset can be classified as:
 Direct or own return (q).
 Carrying cost (c).
 Convenience or security yield (l).
 Expected capital gain or loss (g).
 Reasonably assume every asset yields same return.
 Otherwise, investors would sell assets with low
yields and buy those with high yields. As a result:
qi + ci + li + gi = qj + cj + lj + gj
Econ 512
Dr. Reyadh Faras
1.7 Asset Market Efficiency




The main types of efficiency are:
Allocative efficiency (pareto efficiency)
Operational efficiency (industrial efficiency)
Informational efficiency (asset prices as
reflections of inf. available to investors.)
 Portfolio efficiency (small return variance)
 Operational and informational efficiencies
are the most extensively used in fin. analysis
Econ 512
Dr. Reyadh Faras