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Chapter 1-3&5.4

COMMERCE 2FA3 Chapter Notes - Chapter 1-3&5.4: Capital Asset Pricing Model

Course Code
Richard Deaves

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Why Do We Need Financial Markets?
Primary purpose of financial markets is to transfer funds from those with excess
to those with insufficient
Surplus units: those with excess funds
Deficit units: those with insufficient funds
Most important function of financial markets: allow for the transfer of funds from
savers to units with productive opportunities
Productive opportunities can be possessed by various forms of business units
For an investment to be worth it:
(Inflow/Outflow) – 1 > r
r = interest rate on loan
Projects that cannot earn r% should not continue
Projects that can earn more than r% should continue
Need to think in terms of opportunity cost
Ex. you are considering an investment. You would have to put out $25,000 of your own
money to finance this investment. You believe by the end of the year you will end up with
$30,000. Is this a good investment?
The return is 30/25-1 = 20% so this is a good investment if the interest rate is less than
Where Do Interest Rates Come From?
Interest rate is the price of resources today in terms of resources that must be
repaid at some future date
Supply of loanable funds (S) is positively related to rate of interest
oThe greater the reward for supplying capital, the greater the amount
supplied will be
Demand for loanable funds (D) is negatively related to rate of interest
oThe greater the price of money is, the less will be borrowed
Intersection of two curves determines:
1. Equilibrium interest rate (req)
2. Amount of loanable funds transferred from surplus units to deficit units

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Real rate
interest: in terms of real goods/services not a medium of exchange (ex. in corn
instead of money)
If desire for current consumption is greater than desire for future consumption:
oReal rate of interest will be high
oDemand curve is far to the right relative to supply curve
If society has many potentially profitable investment products:
oDemand curve for loanable funds will be far to right relative to supply
oWill have high rate of interest
Nominal interest rates: expressed in money terms
Real interest rates: nominal interest rates adjusted for effects of inflation
Relationship between nominal and real interest rate:
r = r* + π (Fisher equation)
r = nominal interest rate
r* = real interest rate
= inflation rateπ
If real rate of interest is constant  nominal interest rates will increase one for one
with inflation
International influences on interest rates
Foreign demand for supply of domestic loanable funds can provide a moderating
influence with respect to interest rates
Financial Intermediation and Financial Institutions
Financial institutions: facilitate the process of transfer of funds from surplus units
to deficit units
Ex. banks, insurance companies, investment companies, pension funds
oWhen a party helps match buyers and sellers
oEx. stock brokers, real estate brokers
oNo ownership is taken of asset by facilitator of transaction

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oOwnership position is taken
oEx. bond dealers hold an inventory in selected bonds
oTransmutation of claims
oEx. banks take in deposits and extend loans
oDeposits have no risk
oLoans are risky
oBanks make profit by charging interest rate on loan
Projects Are Usually More Complicated
Riskfree rate: benchmark interest rate based on no risk of any kind
If risk exists:
oBenchmark > riskfree rate
oIncludes risk premium in compensation for risk
Capital Markets and Securities
Assets and Securities
Real assets:
oAllow society to produce foods/services that add to well-being of
oEx. plant and equipment, houses, human capital
Financial assets:
oCertificates or book entries representing legal entitlement to
ownership/promised payments
oEx. bank loans, common stocks
Classify financial securities in several ways:
oEquity securities/equities: represent ownership of firms and their assets
(ex. common stocks)
oFixed-income securities: represent claims to debt payments (ex. bonds)
Money markets: trading of securities with a maturity of less than one year
Capital markets: trading of longer-term instruments
Common Stocks and Returns
Owners of common stocks (shareholders):
oGet paid when company generates cashflows
oOnly get money after all employees, suppliers, tax authorities and
creditors are paid
oHave limited liability (in event of bankruptcy shareholders only lose initial
oHave voting rights (can vote for the board of directors)
Forms of returns from common stock ownership:
oCapital gains: when stock price is above purchase price
oDividends: cash payment declared by board of directors
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