Econ315 Money and Banking: Learning Unit #10: Demand For Assets
- 1. Learning Unit #10 Demand for Assets
- 2. Objectives of Learning Unit #10 This unit and the next introduce the standard demand-supply model of asset markets. This unit focuses on the demand: • Market of Financial Instruments • Determinants of Asset Demand • Concept and Measurement of Risk & Return • Importance of Expectations
- 3. Markets of Financial Assets • To analyze financial markets and how prices of financial instruments are determined in financial markets, we are primarily looking at primary markets where saver/lenders interact with borrower/spenders. Primary Financial Markets Savers Lenders Borrowers Spenders IOUIOU
- 4. Demanders and Suppliers of Financial Assets • In the primary markets, buyers of financial instruments are ones investing on and demanding financial instruments, while sellers of financial instruments are ones issuing (producing) and supplying financial instruments. • Demanders of financial instruments: By purchasing financial instruments, they are providing funds. – Demanders of financial assets are savers/lenders. • Suppliers of financial instruments: By issuing financial instruments, they are borrowing funds. – Suppliers of financial assets are borrower/spemders.
- 5. Quick Review of Demand It is extremely important to distinguish terms “quantity demanded” and “demand.” • Quantity demanded: An amount (quantity) of financial instruments that saver/lenders are willing to purchase for a given conditions (i.e. price, income, risk) − Quantity demanded is a particular number. • Demand: A relationship between the price of financial assets and the quantity demanded, holding all other determinants of quantity demanded constant. − Demand is represented by a table of numbers, or a curve on diagram, or a mathematical function.
- 6. Examples of Quantity demanded and Demand • Quantity demanded: If you earn $50,000, and if a price of Google stock is $200, then you may want to purchase 5 units of Google stock. Quantity demanded is “5 units”. • Demand: Given $50,000 income, you may purchase numbers of Google stock depending on its price. Demand is “1 unit at $500, 5 units at $200, 10 units at $100,...”
- 7. What Affects Your Quantity Demanded for Financial Assets? What may make you willing to buy more or less of Google stocks? • How much wealth and income do you have (do you have spare cash now to buy Google stocks)? • How much profits do you expect to make from Google stocks? • Which one do you like to have, Google stock, Exxon stocks, or Treasury bond? • What else?
- 8. Determinants of Quantity Demanded for Financial Assets There are many factors affecting quantity demanded for a particular financial asset. • Wealth and income • Liquidity • Expected return • Risk • Liquidity, expected return, and risk of other financial assets • Expectation
- 9. Determinants of Quantity Demanded for Financial Assets Among six determinants of quantity demanded for financial assets, • Wealth and income are specific to a particular buyer (saver/lender). • Liquidity, Expected return, & Risk are specific to a particular financial asset. • Liquidity, expected return, and risk of other financial assets include all alternative saving opportunities. • Expectations on all above – your future income, liquidity & risk of a particular financial asset and all other financial assets in future.
- 10. Wealth and Income of Saver • When your wealth and income increase, you are more likely to purchase financial assets. – Can you afford to buy one Google stock at $600? Maybe not now. If you win mega-million lottery, then will you buy Google stocks? maybe. • Wealth of saver ↑ ⇒ Quantity demanded for any financial assets ↑
- 11. Income of All Savers • Quantity demanded for financial assets in the financial market is sum of all quantity demanded by all savers in the market. • Even if you just got a job and started to make more income (lead to more quantity demanded for financial assets), others may have lost incomes (lead to less quantity demanded for financial assets), so in sum the quantity demanded for financial assets may decrease. • It is important to see overall changes in income and wealth of all saver/lenders to figure out an effect on demand for financial assets in market. • National income is one measurement of overall income in the U.S., or Disposable income is a measurement of how much all households in the U.S. can spend or save. – Check Learning Unit 1 for these definitions.
- 12. Liquidity of Asset • Liquidity is how easily or quickly a financial asset can be sold. • In general, saver/lenders prefer financial assets with high liquidity (liquid assets) over others with low liquidity (illiquid assets). – If you have an extra fund now, will you use it to purchase three-year CD or simply deposit it in your checking account. • Liquidity of an asset ↑ ⇒ Quantity demanded for the asset ↑
- 13. Price or Rate of Return on Asset • For goods and services, a price of good is the most important determinant of quantity demanded, because a consumer makes a decision by comparing the price of the good with benefit that a consumer can get from the good. – Is 8GB iPod Nano worth $200 for you? If yes, then you should purchase it at $200, otherwise you shouldn’t. • For financial assets, you do not consume them, instead you gain by selling them later (or simply receiving future cash flows). So, the price of financial asset today is as important as the price of the financial asset when you sell it, and both of them affect your quantity demanded for financial assets. – Should you buy Google stock at $800? It depends. If you expect its price to go up to $900, then you should. On the other hand, if you expect its price to go down to $780, then you should not. • Instead of price of financial assets, a rate of return or interest rate is more relevant determinant of quantity demanded for financial assets.
- 14. Expected Return of Asset • In most cases, you do not know exactly how much rate of return you will get from any financial assets (unless you hold it until its maturity). • There is a chance that you may get a high rate of return, and a chance that you may get even a negative rate of return. • So, you have to make a best guess on rate of return from any financial asset. The best guess in finance and economics in this case is called “Expected return.” • Expected Return: Mean (Average) rate of return or interest rate.
- 15. Expected Return and Quantity Demanded • In general, people prefer a higher rate of return than a lower rate of return, holding all other determinants (such as risk and liquidity) constant. – If Bank of America offers 3% interest rate on a checking account while Wachovia Bank offers 0% interest rate on a checking account, which bank will you open your checking account? • Expected return of an asset ↑ ⇒ Quantity demanded for the asset ↑
- 16. How to Measure Expected Return • Expected return is an average of all possible rates of return. • Formula: Re =Σpi x Ri Re : Expected return pi: Probability of an event i Ri: Rate of return if an event i occurs.
- 17. Example of Measuring Expected Return The U.S. economy may become better or worse. A probability of a better economy is 0.75, while a probability of a worsened economy is 0.25. If the U.S. economy is better, the rate of return on IBM stock will be 60%. If the U.S. economy worsens, the rate of return on IBM stock will be -20%. How much is an expected return on the IBM stock? Re = (0.75)(+60%) + (0.25)(-20%) = 40%
- 18. Expected Return and Actual Return • Since an expected return is a weighted average of possible rates of returns, a saver will never have the “expected” return in reality. An actual rate of return will be one of all possible rates of returns. – It is like a student’s average test score. If she had 80, 98, 76, and 84, her average test score is 84.5. Of course, she never made 84.5 point on any of her tests. – However, like average test score, a saver prefer higher expected return than a lower expected return. • On the previous example, no one will actually get 40% rate of return, every one get either 60% or -20%.
- 19. Risk • A term “risk” is often used as “having something bad or likely to have something bad.” However, in finance and economics, the term “risk” has a special meaning. • Risk: Uncertainty of actual total rate of return • It does not matter whether bad thing to happen or not, as long as you do not know the outcome exactly, then there is a risk. It does not matter whether it costs you or not.
- 20. Examples of Risk • You got a stock free which is currently priced at $0. The price of stock may become $0 or possibly $5 next year. – Although it does not cost you to get a stock and you will never loose from the stock, there is a risk on return from this stock since you do not know whether you get $0 or $5 next year. • You paid $10 to purchase a bankrupted Enron stock (the company no longer exists, so no one will buy it from you). – Although you surely loose $10 from this investment (-100% rate of return), there is no risk because it is certain to loose. • A student studies very hard on a test, so he can make at least B on the test. – There is a risk since he does not know whether he will make B or A (and, of course, possibly C). • A student misses a test with full understanding that a missing test will result in F grade. – No risk since she is surely to get F.
- 21. Risk and Quantity Demanded • In general, a saver does not like risk (risk-averse). – Of course, some people get shrilled on taking risk like buying lottery tickets. But, are you willing to put all of your saving and income to purchase Mega-million lottery tickets? – If you can get a same expected return (5%), which one will you choose, 1 year CD with 5% interest rate (certain) or loaning funds to a stranger for one year with 5% expected return? • Risk of an asset ↑ ⇒ Quantity demanded for the asset ↓
- 22. Measuring Risk • In economics and finance, risk is measured by a standard deviation of rate of return. • A standard deviation will tell you how likely you can get an actual return close to an expected return. – If a standard deviation is zero, then you will get the expected return surely. – If a standard deviation is large, then you may get more likely an actually return far from the expected return, possibly much more or much less than the expected return. • Check your statistics book for calculation of standard deviation.
- 23. Three Types of Risk There are many types (more than ten types) of risk in finance. Here I present three types of risk related to Money & Banking. Default risk: A borrower may not pay the interest or the principal. Purchasing power risk: An actual real rate of return could be higher or lower than one an investor initially expected due to inflation. Interest rate risk: A price of security may change and its total rate of return when the market interest rate changes.
- 24. Default Risk • When you loan your funds to a stranger, there is a possibility that a borrower may not pay back you. • Since any organization has a possibility of bankruptcy, almost all financial instruments have default risk. – Since likelihood of bankruptcy varies from one firm to another, default risk also varies among borrowers. • However, U.S. Treasury securities and any securities backed by the U.S. government do not have default risk. – U.S. government can pay back always by collecting more tax or issuing more cash.
- 25. Purchasing Power Risk • When you purchase securities, you know how much dollars (future cash flows) you will get from the securities and their rates of return (nominal interest rates). • However, you do not know how much goods and service you can purchase from those dollars in future (the real interest rate). • Since no one knows exactly a future inflation rate (even the chairman of Fed), almost all financial instruments have purchasing power risk. • However, inflation-indexed bonds do not have purchasing power risk, since it guarantees a real interest rate.
- 26. Interest Rate Risk • Most savers will not hold securities until their maturities, instead sell them earlier. • Savers cannot predict an exact price of security in future, so the rate of return from the security is uncertain. – Although savers know Pt and C on bonds when they purchase bonds, they do not know Pt+1. – R = (C + Pt+1 – Pt)/Pt x 100 • Among many factors affecting the price of security, the most important factor is the market interest rate. – An inverse relationship: If the interest rate increases, the price of bond will decrease and the rate of return will fall. – Depending on whether the market interest goes up or down, a rate of return may fall or rise in future.
- 27. Risk-Return Trade-off There is a close relationship between rate of return and risk of security. • Higher the risk, higher the return. • Risk premium: The spread between the expected return from a risky asset and the interest rate of risk- free asset. • Lenders do not like risk. In order to make lenders more willing to lend funds, borrowers with high risk must pay an extra-return (risk premium) to compensate such risk.
- 28. Risk Premium Formula • Formula: i = if + RP i: Interest rate on a risky asset if : Interest rate on a risk-free asset RP: Risk premium • In general, we use an interest rate on a comparable U.S. Treasury securities (same maturity, same coupon rate, and same characteristics) as the interest rate on a risk-free asset. • All other securities have some risk, so as risk premium. − Securities with high risk tend to have higher risk premiums.
- 29. Example of Risk Premium • An interest rate on 1-year U.S. Treasury bill is 5%, while the interest rate on a corporate bond is 20%. How much is a risk premium of the corporate bond? • i = 20% on the corporate bond and if = 5% on T-bill ⇒ 20% = 5% + RP ⇒ RP = 15% • How much interest rate are you paying on your credit card (Visa or Master card)? Can you compute a risk premium on your credit card?
- 30. Return, Risk & Liquidity of Other Assets • Without any changes in savers’ wealth and income, the amount of saving is fixed. • If a saver prefers one asset (asset B) more than others (asset A), then her quantity demanded for the asset (asset B) will increase, while her quantity demanded for the other assets (asset A) will decrease. • Savers always compare characteristics (liquidity, expected return, risk) of financial assets and choose one best for them.
- 31. Summary of Relationship among Assets • Liquidity of an asset B ↑ ⇒ Quantity demanded for the asset B ↑ ⇒ Quantity demanded for the asset A ↓ • Expect return of an asset B ↑ ⇒ Quantity demanded for the asset B ↑ ⇒ Quantity demanded for the asset A ↓ • Risk of an asset B ↑ ⇒ Quantity demanded for the asset B ↓ ⇒ Quantity demanded for the asset A ↑
- 32. Expectations • What expected to happen tomorrow will affect the quantity demanded for an asset today. • Since savers purchase financial assets for their saving purposes, their future financial conditions and market conditions at time they plan to sell them. – If you expect to loose your job in several months, will you start saving more (and demanding more financial assets) now for the rainy days? – If you expect a bullish stock market (stock prices are expected to rise continuously), will you buy more stocks now? – If you expect the market interest to increase soon, should you buy bonds now?
- 33. Expectations and Quantity Demanded for Financial Assets •Wealth of saver is expected to ↑ near future ⇒ He starts spending more (and less funds available for saving) now ⇒ Quantity demanded for any assets ↓ now •Liquidity of an asset is expected to ↑ near future ⇒ It will be easier to sell securities in future ⇒ Quantity demanded for the asset ↑ now
- 34. Expectations and Quantity Demanded for Financial Assets •Return of an asset is expected to ↑ near future ⇒ Saver wants to get a higher return. ⇒ Quantity demanded for the asset ↑ now •Risk of an asset is expected to ↑ near future ⇒ It will be more uncertain how much return you may get and possibly loss of return due to higher risk in future ⇒ Quantity demanded for the asset ↓ now
- 35. Summary of Asset Demand Page 90
- 36. Disclaimer Please do not copy, modify, or distribute this presentation without author’s consent. This presentation was created and owned by Dr. Ryoichi Sakano North Carolina A&T State University