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Chapter 11 29
Chapter 11
Asset Markets
This chapter fits in very nicely with the present value calculations in the last
chapter. The idea that all riskless assets should earn the same rate of return in
equilibrium is a very powerful idea, and generally receives inadequate treatment
in intermediate micro texts.
I especially like the arbitrage argument, and showing how it is equivalent to
all assets selling for their present values. The applications of the Hotelling oil
price model and the forest management model are quite compelling to students.
One interesting twist that you might point out in the forestry problem is that
the market value of the standing forest will always be its present value, and that
present value will grow at the rate of interest—like any other asset. However,
the value of the harvested forest will grow more rapidly than the interest rate
until we reach the optimal harvest time, and then grow less rapidly.
The problems in Workouts are quite practical in nature, and it is worth
pointing this out to students. Emphasize that present value calculations are the
meat and potatoes of investment analysis.
Asset Markets
A. Consider a world of perfect certainty. Then all assets must have the same
rate of return.
1. if one asset had a higher rate of return than another, who would buy the
asset with the lower return?
2. how do asset prices adjust? Answer: Riskless arbitrage.
3. this is just another way to say present value.
4. think about the process of adjustment.
B. Example from stock market
1. index futures and underlying assets that make up the futures.
2. no risk in investment, even though asset values are risky, because there is
a fixed relationship between the two assets at the time of expiration.
30 Chapter Highlights
C. Adjustments for differences in characteristics
D. Applications
1. depletable resource — price of oil
2. harvesting a forest
E. This theory tells you relationships that have to hold between asset prices,
given the interest rate.
F. But what determines the interest rate?
G. What do financial institutions do?
1. adjust interest rate so that amount people want to borrow equals amount
2. change pattern of consumption possible over time. Example of college
3. example of entrepreneur and investors
