Financial Markets and Net Present Value: First Principles of Finance (Advanced)

Finance refers to the process by which special markets deal with cash flows over time.These markets are called financial markets. Making investment and financing deci-sions requires an understanding of the basic economic principles of financial markets.This introductory chapter describes a financial market as one that makes it possible for indi-viduals and corporations to borrow and lend. As a consequence, financial markets can beused by individuals to adjust their patterns of consumption over time and by corporations toadjust their patterns of investment spending over time. The main point of this chapter is thatindividuals and corporations can use the financial markets to help them make investment de-cisions. We introduce one of the most important ideas in finance: net present value.


Financial markets develop to facilitate borrowing and lending between individuals. Here wetalk about how this happens. Suppose we describe the economic circumstances of two peo-ple, Tom and Leslie. Both Tom and Leslie have current income of $100,000. Tom is a verypatient person, and some people call him a miser. He wants to consume only $50,000 ofcurrent income and save the rest. Leslie is a very impatient person, and some people callher extravagant. She wants to consume $150,000 this year. Tom and Leslie have differentintertemporal consumption preferences.

Such preferences are personal matters and have more to do with psychology than withfinance. However, it seems that Tom and Leslie could strike a deal: Tom could give up someof his income this year in exchange for future income that Leslie can promise to give him.Tom can lend $50,000 to Leslie, and Leslie can borrow $50,000 from Tom.

Suppose that they do strike this deal, with Tom giving up $50,000 this year in exchangefor $55,000 next year. This is illustrated in Figure 3.1 with the basic cash flow time chart,a representation of the timing and amount of the cash flows. The cash flows that are receivedare represented by an arrow pointing up from the point on the time line at which the cashflow occurs. The cash flows paid out are represented by an arrow pointing down. In otherwords, for each dollar Tom trades away or lends, he gets a commitment to get it back aswell as to receive 10 percent more.

In the language of finance, 10 percent is the annual rate of interest on the loan. Whena dollar is lent out, the repayment of $1.10 can be thought of as being made up of two parts.First, the lender gets the dollar back; that is the principal repayment. Second, the lender re-ceives an interest payment, which is $0.10 in this example.

Now, not only have Tom and Leslie struck a deal, but as a by-product of their bargainthey have created a financial instrument, the IOU. This piece of paper entitles whoever re-ceives it to present it to Leslie in the next year and redeem it for $55,000. Financial instru-ments that entitle whoever possesses them to receive payment are called bearer instrumentsbecause whoever bears them can use them. Presumably there could be more such IOUs inthe economy written by many different lenders and borrowers like Tom and Leslie.

The Anonymous Market

If the borrower does not care whom he has to pay back, and if the lender does not carewhose IOUs he is holding, we could just as well drop Tom’s and Leslie’s names from theircontract. All we need is a record book, in which we could record the fact that Tom has lent$50,000 and Leslie has borrowed $50,000 and that the terms of the loan, the interest rate,are 10 percent. Perhaps another person could keep the records for borrowers and lenders,for a fee, of course. In fact, and this is one of the virtues of such an arrangement, Tom andLeslie wouldn’t even need to meet. Instead of needing to find and trade with each other, theycould each trade with the record keeper. The record keeper could deal with thousands ofsuch borrowers and lenders, none of whom would need to meet the other.

Institutions that perform this sort of market function, matching borrowers and lendersor traders, are called financial intermediaries. Stockbrokers and banks are examples of fi-nancial intermediaries in our modern world. A bank’s depositors lend the bank money, andthe bank makes loans from the funds it has on deposit. In essence, the bank is an interme-diary between the depositors and the ultimate borrowers. To make the market work, wemust be certain that the market clears. By market clearing we mean that the total amountthat people like Tom wish to lend to the market should equal the total amount that peoplelike Leslie wish to borrow.

Market Clearing

If the lenders wish to lend more than the borrowers want to borrow, then presumably the in-terest rate is too high. Because there would not be enough borrowing for all of the lendersat, say, 15 percent, there are really only two ways that the market could be made to clear. Oneis to ration the lenders. For example, if the lenders wish to lend $20 million when interest rates are at 15 percent and the borrowers wish to borrow only $8 million, the market couldtake, say, 8/20 of each dollar, or $0.40, from each of the lenders and distribute it to the bor-rowers. This is one possible scheme for making the market clear, but it is not one that wouldbe sustainable in a free and competitive marketplace. Why not?

To answer this important question, let’s go back to our lender, Tom. Tom sees that in-terest rates are 15 percent and, not surprisingly, rather than simply lending the $50,000 thathe was willing to lend when rates were 10 percent, Tom decides that at the higher rates hewould like to lend more, say $80,000. But since the lenders want to lend more money thanthe borrowers want to borrow, the record keepers tell Tom that they won’t be able to takeall of his $80,000; rather, they will take only 40 percent of it, or $32,000. With the interestrate at 15 percent, people are not willing to borrow enough to match up with all of the loansthat are available at that rate.

Tom is not very pleased with that state of affairs, but he can do something to improvehis situation. Suppose that he knows that Leslie is borrowing $20,000 in the market at the 15percent interest rate. That means that Leslie must repay $20,000 on her loan next year plusthe interest of 15 percent of $20,000 or 0.15  $20,000  $3,000. Suppose that Tom goesto Leslie and offers to lend her the $20,000 for 14 percent. Leslie is happy because she willsave 1 percent on the deal and will need to pay back only $2,800 in interest next year. Thisis $200 less than if she had borrowed from the record keepers. Tom is happy too, because hehas found a way to lend some of the money that the record keepers would not take. The netresult of this transaction is that the record keepers have lost Leslie as a customer. Why shouldshe borrow from them when Tom will lend her the money at a lower interest rate?

Tom and Leslie are not the only ones cutting side deals in the marketplace, and it isclear that the record keepers will not be able to maintain the 15 percent rate. The interestrate must fall if they are to stay in business.
Suppose, then, that the market clears at the rate of 10 percent. At this rate the amountof money that the lenders wish to lend is exactly equal to the amount that the borrowers de-sire. We refer to the interest rate that clears the market, 10 percent in our example, as theequilibrium rate of interest.

In this section we have shown that in the market for loans, bonds or IOUs are traded.These are financial instruments. The interest rate on these loans is set so that the total de-mand for such loans by borrowers equals the total supply of loans by lenders. At a higherinterest rate, lenders wish to supply more loans than are demanded, and if the interest rateis lower than this equilibrium level, borrowers demand more loans than lenders are willingto supply.


In the previous analysis we assumed the individual moves freely along the line AB, and weignored—and assumed that the individual ignored—any effect his borrowing or lending de-cisions might have on the equilibrium interest rate itself. What would happen, though, if thetotal amount of loans outstanding in the market when the person was doing no borrowingor lending was $10 million, and if our person then decided to lend, say, $5 million? Hislending would be half as much as the rest of the market put together, and it would not beunreasonable to think that the equilibrium interest rate would fall to induce more borrow-ers into the market to take his additional loans. In such a situation the person would havesome power in the market to influence the equilibrium rate significantly, and he would takethis power into consideration in making his decisions.

In the modern financial market, however, the total amount of borrowing and lending isnot $10 million; rather, as we saw in Chapter 1, it is closer to $10 trillion. In such a hugemarket no one investor or even any single company can have a significant effect (althougha government might). We assume, then, in all of our subsequent discussions and analysesthat the financial market is competitive. By that we mean no individuals or firms think theyhave any effect whatsoever on the interest rates that they face no matter how much bor-rowing, lending, or investing they do. In the language of economics, individuals who re-spond to rates and prices by acting as though they have no influence on them are called pricetakers, and this assumption is sometimes called the price-taking assumption. It is the con-dition of perfectly competitive financial markets (or, more simply, perfect markets). Thefollowing conditions are likely to lead to this:
1. Trading is costless. Access to the financial markets is free.
2. Information about borrowing and lending opportunities is available.
3. There are many traders, and no single trader can have a significant impact on market prices.

How Many Interest Rates Are There in a Competitive Market?

An important point about this one-year market where no defaults can take place is that onlyone interest rate can be quoted in the market at any one time. Suppose that some competingrecord keepers decide to set up a rival market. To attract customers, their business plan is tooffer lower interest rates, say, 9 percent. Their business plan is based on the hope that theywill be able to attract borrowers away from the first market and soon have all of the business.

Their business plan will work, but it will do so beyond their wildest expectations. Theywill indeed attract the borrowers, all $11 million worth of them! But the matter doesn’t stopthere. By offering to borrow and lend at 9 percent when another market is offering 10 per-cent, they have created the proverbial money machine.

The world of finance is populated by sharp-eyed inhabitants who would not let this op-portunity slip by them. Any one of these, whether a borrower or a lender, would go to thenew market and borrow everything he could at the 9-percent rate. At the same time he wasborrowing in the new market, he would also be striking a deal to lend in the old market atthe 10-percent rate. If he could borrow $100 million at 9 percent and lend it at 10 percent,he would be able to net 1 percent, or $1 million, next year. He would repay the $109 mil-lion he owed to the new market from the $110 million he receives when the 10-percent loanshe made in the original market are repaid, pocketing $1 million profit.

This process of striking a deal in one market and an offsetting deal in another marketsimultaneously and at more favorable terms is called arbitrage, and doing it is called arbi-traging. Of course, someone must be paying for all this free money, and it must be the recordkeepers because the borrowers and the lenders are all making money. Our intrepid entre-preneurs will lose their proverbial shirts and go out of business. The moral of this is clear:As soon as different interest rates are offered for essentially the same risk-free loans, arbi-trageurs will take advantage of the situation by borrowing at the low rate and lending at thehigh rate. The gap between the two rates will be closed quickly, and for all practical pur-poses there will be only one rate available in the market.


We have already shown how people use the financial markets to adjust their patterns of con-sumption over time to fit their particular preferences. By borrowing and lending, they cangreatly expand their range of choices. They need only to have access to a market with aninterest rate at which they can borrow and lend.

In the previous section we saw how these savings and consumption decisions dependon the interest rate. The financial markets also provide a benchmark against which proposedinvestments can be compared, and the interest rate is the basis for a test that any proposedinvestment must pass. The financial markets give the individual, the corporation, or eventhe government a standard of comparison for economic decisions. This benchmark is criti-cal when investment decisions are being made.

The way we use the financial markets to aid us in making investment decisions is a di-rect consequence of our basic assumption that individuals can never be made worse off byincreasing the range of choices open to them. People always can make use of the financialmarkets to adjust their savings and consumption by borrowing or lending. An investmentproject is worth undertaking only if it increases the range of choices in the financial mar-kets. To do this the project must be at least as desirable as what is available in the financialmarkets.

2、If it were not as desirable as what the financial markets have to offer, people couldsimply use the financial markets instead of undertaking the investment. This point will gov-ern us in all our investment decisions. It is the first principle of investment decision making,and it is the foundation on which all of our rules are built.

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