Topic 1. Asset Markets and Asset Prices
ECON30024 Economics of Finanical Markets
Shuyun May Li
Department of Economics
The University of Melbourne
Semester 1, 2025
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Outline
1. An overview of financial markets
• Types of financial markets
• Functions of financial markets
• The growth of finance
2. Introduction to asset price determination
• Basic framework
• Role of expectation
• Some important concepts
– Rates of return
– Arbitrage
– Efficiency
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Readings
• Required reading:
– Chap. 1 of Bailey
– Greenwood and Scharfstein (JEP, 2013), “The Growth of
Finance” (Readings Online)
• Supplementary readings:
– The global financial environment (a RBA report)
https://www.rba.gov.au/publications/fsr/2023/apr/global-
financial-environment.html
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1. An Overview of Financial Markets
1.1 Types of financial markets
• Flow of funds in a modern society
• Financial markets encompass a broad, continually evolving
collection of institutions (as a result of financial innovations)
that serve to facilitate the exchange of financial
assets/claims/instruments.
• There are many types of financial markets, depending on
various classifications.
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• By financial assets traded
– Bond markets
– Equity or stock markets
– Asset or mortgage backed securities markets
– Foreign exchange markets
– Commodity markets
– Derivatives markets: futures, options, credit default swaps
• By seasoning of the asset:
– Primary markets are where financial assets are initially
issued by borrowers of funds.
– Secondary markets are where previously issued financial
assets are traded among investors.
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• By organisational structure:
– Exchange-traded: centralised, primarily used to trade
stocks
– Over-the-counter (OTC): decentralised, dealers acting as
market-makers, less transparent, primarily used to trade
bonds, currencies, derivatives, and structured products
• By maturity of the asset
– Money markets: deal with short-term claims which have
high liquidity and low default risk.
– Capital markets: deal with stock or longer-term debt
instruments which are less marketable, have varying default
risks and longer maturities.
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1.2 Functions of financial markets
• Facilitating flow of funds from suppliers to borrowers is a
fundamental function of the financial system, which allows the
real economy to be financed and risks to be shared.
– Ways of serving the real economy (discussion on Miro)
(https://miro.com/app/board/uXjVIbyLTfU=/)
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• More specifically, functions of financial markets, which are
more stable than their institutions, can be classified as:
– Clearing and settling payments
– Pooling resources and subdividing shares
– Transferring resources across time and space
– Managing risk
– Providing information
– Dealing with incentive problems
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• A well functioning financial market should offer:
– Price discovery: asset prices are properly determined
– Liquidity: ability to convert financial assets into cash at
low cost and with little price impact
– Low transaction costs: low search costs in finding a
counterparty and low information costs in assessing the
merits of assets
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1.3 The Growth of Finance
• The financial sector has grown enormously in past few decades.
• For example, Greenwood and Scharfstein (2013) document for
the U.S.
– the value of financial assets was 10 times of GDP in 2007
(5 times in 1980)
– the sector contributed 8.3% to GDP in 2006 (4.9% in 1980)
– the average wage rate in this sector was 70% higher than in
other industries in 2006 (about the same in 1980)
• In Assignment 1, you’ll be asked to document some facts on
the growth of finance in Australia.
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• Much of the growth of finance is associated with two activities:
asset management and the provision of household credit.
– The value of financial assets under professional management
grew dramatically, so as the fees charged to manage these
assets.
– Household credit increased from 48% of GDP in 1980 to
99% in 2007, with most growth in residential mortgages.
· Leading to growth in fees on loan origination,
underwriting, trading and management of MBS and
derivatives.
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Growth of financial services in the US
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• Reflection on the social benefits and costs of the growth in
finance (see Greenwood and Scharfstein (2013)).
– Has the society benefited from the growth of professional
asset management?
– Shadow banking, which greatly facilitated the expansion of
household credit, could have made the financial system
more fragile.
– Increases in household indebtedness can have adverse
consequences for macroeconomic stability.
– This will be further discussed in Tutorial 1.
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2. Introduction to Asset Price Determination
• The concept of financial asset
– Most assets are categorised as either real, financial, or
intangible
– A financial asset is a tangible liquid asset that gets its value
from a contractual claim on an underlying asset
(cash, bank deposits, stocks, bonds)
– Financial assets do not necessarily have inherent physical
worth.
– In this subject, “assets” refer to “financial assets”.
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• The focus of this subject is to present some important theories
of asset price determination and their applications.
• In previous economics subjects, the focus is on the
determination of price and quantity of goods.
• Differences between goods and assets (discussion)
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2.1 Basic analytical framework
• Prices are determined by supply and demand for assets.
– Who supplies (sells) assets?
– Who demands (buys) assets?
• Equilibrium prices are defined to be prices that clear markets
(by equating demand and supply) at each date.
• Supply or total stock of an asset at a given date is assumed to
be given.
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• What determines the demand for assets? Investors choose their
portfolio given
– prices of assets
– preferences
– beliefs (about assets’ future payoffs)
– constraints (budget constraints, institutional constraints)
That is, a theory of portfolio choice under uncertainty is
needed –portfolio selection.
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• The market equilibrium at each date is defined by a set of asset
prices and an allocation (portfolio) of assets among investors
that satisfy:
(a) Individual optimality: Given the equilibrium asset
prices, each investor’s portfolio is optimal subject to the
investor’s preferences, beliefs, and constraints;
(b) Market clearing: Demand equals supply, i.e., the total
stock of each asset equals the total demand aggregated over
all investors.
• The captial asset pricing model (CAPM) exactly follows this
framework.
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2.2 Role of expectation
• It’s clear from the basic framework that investors’ portfolio
selection is forward looking.
– Future payoffs of assets are taken into account in making
the portfolio decision today.
– For almost all assets, the payoff is, at least in part,
uncertain, when viewed from today.
– Investors need to form belief or expectations about future
payoffs.
• How do people form expectations?
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• Conventional economics assumes rational expectations
(RE): investors’ expectations are formed with an awareness of
all the forces that determine future payoffs.
• Although the RE assumption is too ideal, we’ll maintain this
assumption in our analysis.
• There has been development in behavioural finance, which
proposes psychology-based theories to explain financial
market bahaviour.
– A brief introduction will be given in Topic 11.
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2.3 Some important concepts
• Rates of return: The rate of return on an asset is given by
rt+1 ≡
payofft,t+1 − pricet
pricet
=
vt+1 − Pt
Pt
– Gross rate of return on an asset: 1 + rt+1
– An asset’s payoff may have several components depending
on the type of asset:
vt+1 = Pt+1 + dt+1, rt+1 =
Pt+1 + dt+1 − Pt
Pt
– vt+1 and hence rt+1 are usually random variables.
Etrt+1 =
Etvt+1 − Pt
Pt
– Given expected payoff, asset price determination is
equivalent to determination of expected return.
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• See Bailey, Appendix 1.3, for the concept of continuous
compounding.
• Arbitrage
– It is a common understanding that observed market prices
should reflect the absence of arbitrage opportunities,
or the arbitrage principle.
– If arbitrage opportunities are present, then investors could
design strategies that yield unlimited profits with certainty
(Tutorial 1).
– If financial markets are frictionless, the arbitrage principle
implies connections among the prices of different assets.
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– Example: The following information is provided for
frictionless assets market. What p1 should be to ensure
absence of arbitrage opportunities?
Asset 1 Asset 2
Dividend next period 15 9
Price next period 216 156
Price today p1 150
Answer:
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– The arbitrage principle provides a partial theory of asset
prices (to be explored more formally in Topic 6).
– However, when frictions are pervasive, few implications
about asset prices can be drawn even if arbitrage
opportunities are absent (Tutorial 1).
– Common market frictions:
· transaction costs
· institutional restrictions on trade
· borrowing constraints
· indivisible assets
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• ‘Perfect’ financial market: frictionless and competitive
• Efficiency: Financial market efficiency has several meanings:
– Allocative efficiency (Pareto efficiency): Does the market
allocate resources efficiently?
– Operational efficiency: Is the market organised efficiently?
– Informational efficiency: Do asset prices fully reflect the
information available to investors? (Topic 2)
– Portfolio efficiency: whether all portfolios chosen by
investors are efficient, in the sense that the variance of
return is minimised for any level of expected return?
(Topic 4)
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Review Questions
• Carefully read through the Subject Guide and the List of Important
Subject Policies. Be clear with the policies and expectations.
• Understand the flow of funds in a modern society.
• Understand the different types of financial markets by difference
classification
• Why the institutions of financial markets are continually evolving?
Think of a few institutional changes in recent years.
• Understand the difference between bond and equity (refer to Bailey,
if you are not clear).
• What is the fundamental function of financial markets? Name a few
specific functions of financial markets.
• Have a general understanding of the growth in finance in past few
decades, and the possible social benefits and costs of such growth.
• Understand the difference between financial assets and real assets.
• Understand the difference between assets and goods.
• Understand the basic theoretical framework for asset price
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determination: supply, demand, market clearing.
• Why expectation plays such an important role in asset price
determination? What is the rational expectations assumption?
• Understand the concepts of rate of return, real rate of return,
continuous compounding, force of interest. Be able to calculate the
rate of return and force of interest.
• Try to understand why the absence of arbitrage opportunities serves
to link prices of different assets in a frictionless market in view of
the example given (another example to be given in Tutorial 1).
• Have a general understanding of several common market frictions.
• Is this statement true: when market frictions are pervasive, the
arbitrage principle would not hold.
• Understand the different meanings of asset market efficiency.
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