fin10 - Financial Markets Econ 333 Spring 08 1 Financial...

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Econ 333 Spring 08 1 Financial Markets
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Econ 333 Spring 08 2 Financial Markets Having considered the general principles of asset pricing, we now apply these to three key financial markets: The stock market, the bond market, and the foreign exchange (FOREX) market. Each market has specific features that need to be taken into account which make the analysis very different. Their common feature is that they all satisfy the general equilibrium pricing equation: And hence the no-arbitrage condition is the coefficient of relative risk aversion and is the stochastic discount factor or marginal rate of substitution. 1 ] ) 1 [( 1 1 , = + + + t t i t M r E ) , cov( ) 1 ( 1 , 1 1 , f t i t t f t f t i t r r c c r r r E + = + + + βσ t σ ) ( ' ) ( ' 1 1 t t C U C U t M + = + β
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Econ 333 Spring 08 3 Financial Markets In general, Where Pt is the price of an asset at the start of period t, and Xt+1 is its payoff at the start of period t+1. The payoffs define the different assets. For example: For a stock which pays a dividend of Dt+1 and has a resale value of Pt+1 at t+1, we have Xt+1=Pt+1 + Dt+1 For a Treasury bill that pays one unit of the consumption good regardless of the state of the nature next period, Xt+1 = 1, and the price is then Pt = 1/(1+rf) For a bond that has a constant coupon payment of C and can be sold for Pt+1 next period, Xt+1 = Pt+1 + C For a bank deposit that pays the risk-free rate of return rf between t and t+1, Xt+1 = 1+rf, and the price is Pt=1. For a call option that gives the holder the right to purchase a stock at the exercise price K at date T, the future payoff on the asset is Xt = max[St-K,0], and Pt is the price paid to purchase the option. t t P X t r 1 1 1 + = + +
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Econ 333 Spring 08 4 The Stock market: Discussing the PVM The traditional valuation model for equity is the present-value model (PVM). This assumes that the marginal rate of substitution so that the expected rate of return to equity in period t+1 based on information available in period t is alpha, which is a constant. Therefore it assumes that there is no risk premium, or that the risk-free rate is constant. It can be shown that the price of equity is (proof in class) That is, Pt is the present value of discounted current and future dividends. Unsurprisingly, despite its widespread use, the evidence strongly rejects the present-value model. ) 1 /( 1 1 α + = + t M = + + = 1 ) 1 ( i D E t i i t t P
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Econ 333 Spring 08 5 The Stock market: Discussing the PVM The Gordon Dividend-Growth model : A variant of the PVM in which the expected rate of growth of dividends is assumed to be constant but nonzero. We shall show that the expected return on equity is related to average earnings per
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This note was uploaded on 05/21/2008 for the course ECON 3330 taught by Professor Mbiekop during the Spring '08 term at Cornell.

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fin10 - Financial Markets Econ 333 Spring 08 1 Financial...

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