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Chapter 4

COMM 121 Chapter Notes - Chapter 4: Arbitrage, Net Present Value, Financial Instrument

Course Code
COMM 121
Blair Robertson

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Chapter 4: Financial Markets and Net Present Value: First Principles of Finance
The Financial Market Economy
Interest rate: The annual percentage return made/owed on a loan
Principle: The initial value of the loan that must be paid back at maturity
Bearer Instruments: A financial instrument that entitles whoever possesses it to get paid
The Anonymous Market
Financial Intermediaries are institutions that provide the market function of matching
borrowers and lenders (for a fee) these two people never have to meet
Market Clearing
If lenders want to lend out more than borrowers want, the interest rate is likely too high
o This will lead people to create side deals at a slightly lower interest rate so that
they can invest all of their money
o Eventually interest rates will drop until the equilibrium rate of interest is hit
The Equilibrium rate of interest is the interest rates that clears the market lenders are
willing and able to lend out and all that borrowers are willing and able to borrow
Making Consumption Choices over Time
Refer to in slides in class math based examples about spending all money now taking into
account the current interest rate or saving everything and spending it next year and earning the
interest rate
Remember that a bigger interest rate leads to more spending in the future and less spending now
where are a lower interest rate leads to spending more now and spending less in the future
The Competitive Market
In a huge market, no one single investor has the power to change the eql’m interest rate
o In the rest of analysis we assume that the financial market is perfectly competitive
Perfectly competitive financial markets (above definition) have these characteristics
o Trading is costless access to financial markets is free
o Info about borrowing and lending opportunities is readily available
o There are many traders, and no single trader significantly impacts market prices
How Many Interest Rates Are There in a Competitive Market?
In this one-year market w. no defaults there can only be 1 quoted interest rate at any time
If a market lends 10% and then another lends 9% to try and get clients, it will work
o But people will borrow all they can from 9% and lend it to 10% to make money:
this process is known as arbitrage
o This gap will be closed quickly as people try to take advantage of the difference
and there will only be one interest rate in the market
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