CFA Level I Study Session

1
CFA Level I Study Session 5

• Investment Tools -
• Microeconomic Analysis

2
CFA Level I Study Session 5.1A

• Demand and Consumer Choice
• including addendum
• Consumer Choice and Indifference Curves

3
Demand and Consumer Choice

• The candidate should be able to
• explain consumer choice in an economic framework
• Principles behind Consumer Choice
• Limited income versus unlimited desires
  necessitates choices.
• Consumers make rational choices to achieve their
  goals.
• Consumers can substitute between like goods.
• Consumers make decisions based on less than
  perfect information.
• Law of Diminishing Marginal Utility As
  consumption of a good increases, the additional
  utility derived eventually declines.
• Consumer Behavior in making Choices
• Consumer will adjust consumption of a good until
  the marginal utility of consuming the good just
  equals the price of the good.
• Consumer Demand Curve Diminishing Marginal
  Utility implies that as the price of a good
  rises, the amount demanded by the consumer should
  fall.
• Income a substitution effect associated with
  change in price.

4
Demand and Consumer Choice

• identify, describe, and calculate the
  determinants of price and income elasticity of
  demand
• () identify and discuss the determinants of
  price and income elasticity of demand
• Price Elasticity of Demand DQd DP
• where DQd (Qd1 Qd0)/(Qd1 Qd0)/2, etc.
• Is always NEGATIVE
• Increase in price DP gt will always reduce the
  quantity demanded DQd lt 0.
• Shows degree of consumer responsive to variations
  in goods price.
• Price Elasticity affected by
• Availability of Substitutes more substitutes,
  more elastic demand,
• Share of Total Budget spent on Good smaller
  share then less elastic the demand
• Length of Time period longer the time period,
  more elastic the demand.

5
Demand and Consumer Choice

• identify, describe, and calculate the
  determinants of price and income elasticity of
  demand
• () identify and discuss the determinants of
  price and income elasticity of demand
• Income Elasticity of Demand DQd DIncome
  
• where DQd (Qd1 Qd0)/(Qd1 Qd0)/2, etc.
• Shows degree of consumer responsive to variations
  income.
• Income Elasticity affected by
• Normal Goods positive income elasticity, demand
  rises with income.
• Luxuries high positive elasticity, demand rises
  strongly with income.
• Inferior Goods negative income elasticity,
  demand falls with income.

6
Elasticity and Total Revenue

• d. () describe the relationships among total
  revenue, total expenditures, and price elasticity
  of demand
• Dexpenditures ? Dprice Dquantity
• Inelastic Demand when elasticity of demand is
  less than one in absolute value, a 10 fall in
  price increases quantity demanded by less than
  10. Thus total expenditure by consumers, and
  total revenue received by firms, falls.
• Elastic Demand when elasticity of demand is
  greater than one in absolute value, a 10 fall in
  price increases quantity demanded by more than
  10. Thus total expenditure by consumers, and
  total revenue received by firms, rises.

7
Demand and Consumer Choice

• The candidate should be able to
• explain why price elasticity of demand tends to
  increase in the long run.
• Second Law of Demand buyers response will be
  greater after they have had time to adjust more
  fully to a price change. Why?
• Better able to rearrange consumption patterns to
  take advantage of substitutes.
• discuss the characteristics of consumer
  indifference curves.
• More goods are preferable to fewer goods, thus
  points to upper right preferred to points in
  lower left of utility curve diagram.
• Goods are substitutable, hence utility curves
  slope downward to the right.
• Diminishing marginal rate of substitution between
  goods implies utility curves always convex to
  origin.
• Indifference curves are everywhere dense, i.e.
  one through every point.
• Indifference curves cannot cross because if they
  did then individual would not be following a
  rational ordering.

8
Demand and Consumer Choice

• The candidate should be able to
• discuss the role of the consumption opportunity
  constraint and the budget constraint in
  indifference analysis.
• Consumption opportunity constraint separates
  consumption bundles that are attainable from
  those that are unattainable.
• In money-income economy, usually same as budget
  constraint.
• Budget constraint separates consumption bundles
  that consumer can purchase from those that cannot
  be purchased, given the consumers limited income
  and the market prices of the products involved.
• Consumers choice determined by the point at
  which their highest indifference curve touches
  the budget (or consumption opportunity)
  constraint.
• This point yields highest level of utility for
  given level of income and market prices.

9
describe, and distinguish between, the income
effect and the substitution effect.
1. At original prices, Consumer chooses point A.
Good Y
A
U0
Good X
10
CFA Level I Study Session 5.1B

• Costs and the Supply of Goods

11
Costs and the Supply of Goods

• The candidate should be able to
• describe the principalagent problem of the firm
• Principal-Agent Problem
• Incentives of principal (purchaser of service)
  and agent (seller of service) can diverge if
  principal cannot observe agents performance.
• Agent will pursue own goals, which may only
  partially overlap with the goals of the principal
  who has purchased the agents services.

12
Costs and the Supply of Goods

• () distinguish among the types of business
  firms
• Proprietorship Business owned by an individual
  who possesses the ownership rights to the firms
  profits and is personally liable for the firms
  debts.
• Partnership Business owned by two or more
  individuals who possesses the ownership rights to
  the firms profits and is personally liable for
  the firms debts.
• Corporation Business owned by shareholders who
  have the ownership rights to the firms profits
  but whose liability is limited to the amount of
  their initial investment in the firm.

13
Costs and the Supply of Goods

• The candidate should be able to
• distinguish between (1) explicit costs and
  implicit costs, (2) economic profit and
  accounting profit, and (3) the short run and the
  long run in production
• Explicit Costs Payments by a firm to purchase
  productive resources.
• Implicit Costs Opportunity costs of a firms use
  of resources that it owns. These costs do not
  involve direct payments.
• Economic Profit Difference between firms total
  revenue total cost.
• Accounting Profit Firm revenue minus expenses
  over given time period. Does not take implicit
  costs into account.
• Short-Run in Production Time period short enough
  so not all factors of production can be adjusted.
  Typically plant size fixed.
• Long-Run In Production Time period long enough
  so all factors of production can be adjusted.

14
Costs and the Supply of Goods

• The candidate should be able to
• define various types of costs, including
  opportunity costs, sunk costs, fixed costs,
  variable costs, marginal costs, average costs
• Total Fixed Costs, TFC
• Sum of costs that do not vary with level of
  output.
• Total Variable Costs, TVC
• Sum of costs that change with the level of
  output.
• Marginal Cost, MC MC DTC/Dq TC TFC TVC
• Change in total cost required to produce an
  additional unit of output.
• Average Costs
• Average Fixed Cost AFC TFC/quantity produced
• Average Variable Cost AVC TVC/quantity
  produced
• Average Total Cost ATC AFC AVC
  TC/quantity produced
• Sunk Costs
• Costs that have already been incurred as the
  result of past decisions.

15
Cost Curve Relationships
Costs
MC always cuts ATC and AVC at their minimum
points!
Quantity, q
16
Costs and the Supply of Goods

• state the law of diminishing returns explain
  its impact on a firms costs
• Law of Diminishing Returns to a Factor of
  Production
• As more and more units of a variable input are
  combined with a fixed amount of another input,
  the additional units of the variable input will
  yield increased output at a decreasing rate.
• () describe and explain the shapes of the
  short-run marginal cost, average variable cost,
  average fixed cost, and average total cost
  curves
• Once reach a level of output where diminishing
  returns occur, larger and larger additions of the
  variable factor are necessary to increase output
  by one more unit.
• Result is MC of the additional output increases.
  So long as MC is below ATC, producing additional
  units of output will bring down the ATC curve.
• At some point, however, MC will rise by enough to
  exceed ATC.
• After the point where MC ATC, additional units
  of output will raise ATC causing the ATC curve to
  be U-shaped. Thus the MC curve will cut the ATC
  curve at its minimum point.

17
Costs and the Supply of Goods

• The candidate should be able to
• define economies and diseconomies of scale,
  explain how they each is possible, and relate
  each to the shape of a firms long-run average
  total cost curve
• Economies of Scale Reductions in firms per unit
  costs as all factors of production are increased
  in an optimal way.
• Possible reasons 1) Mass production, 2)
  specialization of factors of production, and 3)
  learning by doing scale economies.
• Diseconomies of Scale Increases in firms per
  unit costs as all factors of production are
  increased in an optimal way.
• Possible reasons 1) coordination inefficiencies,
  2) increasing difficulties in conveying
  information, and 3) increased principal-agent
  problems.
• Constant Returns to Scale No change in firms
  per unit costs as all factors of production are
  increased in an optimal way.

18
Economies Diseconomies of Scale
Costs
Quantity, q
19
Costs and the Supply of Goods

• The candidate should be able to
• describe the factors that cause cost curves to
  shift.
• Factors that Cause Cost Curves to Shift
• Prices of Resources Increase in price of
  resources used (inputs to production) will cause
  a firms cost curves to shift upwards.
• Taxes Increased taxes shift up a firms cost
  curves. Tax on variable input shifts MC, AVC,
  ATC. Fixed tax shifts AFC ATC.
• Technology Cost-reducing technological
  improvements will lower a firms cost curves.
  Which curves depend on whether technology affects
  fixed or variable costs.

20
CFA Level I Study Session 5.1C

• Price Takers and the Competitive Process

21
Price Takers Competitive Process

• The candidate should be able to
• distinguish between price takers and price
  searchers
• Price-Takers
• Firms that take market price as given when
  selling their product. Each is small relative to
  market, cannot affect price.
• Price-Searchers
• Firms that face a downward-sloping demand curve
  for their product. Price charged by firm affects
  amount it sells.
• discuss the conditions that characterize a purely
  competitive market
• Purely Competitive Markets
• Markets characterized by large number of small
  firms producing identical products in industry
  with complete freedom or entry/exit.
• Also termed price-taker markets.

22
Price Takers Competitive Process

• The candidate should be able to
• explain how and why price takers maximize profits
  at the quantity for which marginal cost price
  marginal revenue
• Marginal Revenue of each unit of output sold
  Market Price.
• Price-taking firm sets output so Marginal Cost of
  last unit of output produced equals market price
  marginal revenue.
• If MR gt MC then selling an additional unit adds
  to profit.
• If MR lt MC then selling additional unit lowers
  profit.
• Maximum profit when MR P MC of last unit.
• () calculate and interpret the total revenue and
  the marginal revenue for a price taker
• For a price taker, total revenue is simply equal
  to the price in the market times the number of
  units of output sold.
• Marginal revenue, the change in total
  revenue/change in output, is constant for a price
  taker and equal to the market price of the
  product.

23
Price Takers Competitive Process

• () explain the decision by price takers with
  economic losses to either continue to operate,
  shut down, or go out of business
• A firm that is making losses, i.e. ATC gt P, will
  choose to continue to operate in the short-run so
  long as
• it can cover all its variable costs, i.e. P gt AVC
  and
• it expects price to be high enough to cover its
  average cost in the future.
• In the short run, the firm must pay its fixed
  costs even if it shuts down. So long as price
  exceeds average variable cost, the firm will be
  able to pay part of its fixed costs.
• This strategy makes sense so long as the firm
  expects that at some point price will rise
  sufficiently to cover both its variable and fixed
  costs, i.e. P ATC.

24
Price Takers Competitive Process

• describe the short-run supply curve for a firm
  and for a competitive market
• SR Supply for Individual Firm Marginal Cost
  curve above AVC.
• SR Supply for Market horizontal sum of all the
  marginal cost curves of firms in the industry.

25
SR Equilib. Price-Taker Market
Price, p
MC SR Supply above PMin
ATC
AVC
SR Profits
SR Losses
pmin
Quantity, q
26
Price Takers Competitive Process

• The candidate should be able to
• contrast the role of constant cost,
  increasing-cost, and decreasing-cost industries
  in determining the shape of a long-run market
  supply curve.
• Long Run Supply Curve shows minimum price that
  firms will supply any level of market output,
  given sufficient time to adjust all factors of
  production allow for any entry/exit from the
  industry.
• Economies of Scale determine Shape of LR Supply
• Constant Returns to Scale (i.e. Constant cost)
  industry will have horizontal LR Supply Curve.
• Increasing Returns to Scale (i.e. Declining cost)
  industry will have downward-sloping LR Supply
  Curve.
• Decreasing Returns to Scale (i.e. Increasing
  cost) industry will have upward-sloping LR Supply
  Curve.

27
Price Takers Competitive Process

• The candidate should be able to
• explain the impact of time on the elasticity of
  supply.
• Elasticity of supply usually increases in long
  run as more time is allowed to firms to adjust
  production in response to changes in prices.
• Over time, firms can adjust the levels of all
  factors of production in optimal ways to meet
  changes in price.

28
CFA Level I Study Session 5.1D

• Price-Searcher Markets with
• Low Entry Barriers

29
Markets with Low Entry Barriers

• The candidate should be able to
• describe the conditions that characterize
  competitive price-searcher markets
• Competitive Price-Searcher Markets
• Each firm faces a downward-sloping demand curve
  for their output.
• Firms produce differentiated products. Output of
  other firms close substitutes, so individual
  firms demand curve is highly elastic.
• Low entry barriers allow entry or exit of firms
  if existing firms earn non-zero economic profits.
  Each firm faces competition from existing firms
  in industry potential new entrants.
• explain how price searchers choose price and
  output combinations
• Profit-maximizing Behavior for a Price Searcher
• Sets output level so that Marginal Cost equal to
  Marginal Revenue.
• For Price Searcher, Marginal Revenue is related
  to shape of the Demand Curve. Intuition for two
  factors at work to sell additional unit of output.

30
SR Monopolistic Competition
1. Each firm has set of cost curves
Price, p
MC
ATC
Quantity, q
31
LR Monopolistic Competition
Price, p
MC
ATC
Quantity, q
32
Markets with Low Entry Barriers

• The candidate should be able to
• summarize the debate about the efficiency of
  price-searcher markets with low barriers to
  entry, including the concepts of contestable
  markets, entrepreneurship, allocative efficiency,
  and price discrimination
• () In the long run, competition along with free
  entry and exit will drive prices down to level of
  average costs.
• Contestable markets market where costs of entry
  or exit are low, so firms risk little by entry.
• Efficient production and zero economic profits
  should prevail.
• Market can be contestable even if capital
  requirements for entry are high.
• (-) LR equilibrium is not allocatively efficient,
  however, because firms produce less than the
  minimum ATC level of output.
• Advertising in differentiated product markets may
  be wasteful self-defeating.
• Benefits of dynamic competition improves customer
  choices of quality and convenience versus
  trade-off of higher prices.

33
Markets with Low Entry Barriers

• The candidate should be able to
• explain how price discrimination increases output
  and reduces allocative inefficiency
• Price discrimination occurs when a producer
  charges different consumers different prices for
  the same product.
• Requires supplier able to identify and separate
  at least two groups with different price
  elasticities, and
• Prevent those buying at low price from reselling
  to higher priced customers.
• Segmentation of groups with different price
  elasticities allows suppliers to charge different
  prices to each, possibly resulting in higher
  profits than with single price alone.
• On balance output in industry higher with price
  discrimination than without. Moves industry
  output closer to competitive output level
  associated with allocative efficiency.

34
Price Discriminating Monopolist
Cost, C and Price, P
Cost, C and Price, P
Single Price
Price Discrimination
Single Price Profit
MC
MC
D
D
MR
Quantity, Q
Quantity, Q
QCompetitive
QCompetitive
35
Markets with Low Entry Barriers

• The candidate should be able to
• explain why competition is an important
  disciplinary force in a market where barriers to
  entry are low.
• Competition places pressure on producers to
  operate efficiently and cater to preferences of
  customers.
• Competition provides firms with strong incentive
  to develop improved products and discover
  lower-cost production methods. (entrepreneurs
  innovation)
• Competition causes firms to discover the type of
  business structure and size that best keep per
  unit costs of production low.

36
CFA Level I Study Session 5.1E

• Price-Searcher Markets with High Entry Barriers

37
Markets with High Entry Barriers

• The candidate should be able to
• discuss entry barriers that protect some firms
  against competition from potential market
  entrants
• Economies of Scale Large fixed costs mean
  decreasing per unit costs.
• Government Licensing Legal barriers to entry
  established by govt.
• Patents Property rights given to newly invented
  products or processes.
• Control over an Essential Resource Single firm
  has control over an essential resource or
  technology.
• distinguish between the characteristics of a
  monopoly and those of an oligopoly
• Monopoly is a market characterized by
• Single seller of a well-defined product with no
  good substitutes.
• High barriers to entry of any other firms into
  market for the product.

38
Markets with High Entry Barriers

• The candidate should be able to
• distinguish between the characteristics of a
  monopoly and those of an oligopoly.
• Oligopoly is a market characterized by
• Small number of rival firms in industry.
• Interdependence among sellers as each is large
  relative to market.
• Substantial economies of scale in production of
  the good.
• High barriers to entry firms into market.
• describe how a profit-maximizing monopolist sets
  prices and determines output
• Profit-maximizing Behavior for a Monopolist
• Sets output level so that Marginal Cost equal to
  Marginal Revenue.
• Marginal Revenue is related to shape of the
  Demand Curve. Intuition for two factors at work
  to sell additional unit of output.

39
Profit-Maximizing Monopolist
Cost, C and Price, p
Quantity, q
40
Markets with High Entry Barriers

• The candidate should be able to
• () discuss price and output under oligopoly,
  with and without collusion
• With Collusion
• Under collusion, i.e. acting as a cartel,
  oligopolists can coordinate supply decisions to
  maximize the joint profits of all the firms. The
  cartel essentially acts like a monopolist in
  market, setting higher price and lower output in
  order to generate positive economic profits.
• Without Collusion
• Once the collusion by the cartel has
  established the monopoly price in the market,
  each member of the cartel has an incentive to
  cheat by increasing their own supply at the high
  price to increase its share of profits in the
  market. Thus without collusion, the oligopolists
  end up competing with one another on prices,
  driving the market outcome to that associated
  with perfect competition, where price is lower,
  output is higher, and all firms earn zero
  economic profits.

41
Markets with High Entry Barriers

• The candidate should be able to
• discuss why oligopolists have a strong incentive
  to collude and to cheat on collusive agreements
• By colluding, i.e. acting as a cartel,
  oligopolists can coordinate supply decisions to
  maximize the joint profits of all the firms.
  Cartel seeks to create a monopoly in market.
• Once collusion by the cartel has established the
  monopoly price in the market, however, each
  member of the cartel has an incentive to cheat by
  increasing their own supply at the high price to
  increase its share of profits in the market.

42
Markets with High Entry Barriers

• The candidate should be able to
• discuss the obstacles to collusion among
  oligopolistic firms
• Incentive for any firm to cheat on cartel
  agreement to increase its profits. Obstacles to
  success of collusion
• Increase in number of firms making up oligopoly.
• If price cuts by individual firms difficult to
  detect prevent.
• Low barriers to entry. Successful collusion
  induces new entrants.
• Unstable demand conditions lower likelihood
  collusion successful.
• Vigorous antitrust actions increase cost of
  collusion.

43
Markets with High Entry Barriers

• The candidate should be able to
• review government policy alternatives to reduce
  the problems stemming from high barriers to
  entry.
• Restructure existing firm or firms to stimulate
  competition.
• May not be possible if economies of scale form
  barrier. Natural monopoly occurs if declining per
  unit costs of large range of output.
• Reduce Artificial Barriers to Trade
• If few firms dominate domestic market, may get
  increased competition by encouraging foreign
  firms to supply market.
• Regulate the Dominant Producer(s)
• Government may regulate price charged by
  monopolist or oligopolists in the market to
  achieve more efficient outcomes.
• Average Cost Pricing set output so ATC Demand
  Curve
• Marginal Cost Pricing set output so MC Demand
  Curve
• Supply Market with Government Production
• Particularly appropriate for public goods.
  Concerns about efficiency.

44
Problems with Natural Monopoly
Cost, C and Price, p
ATC
MC
Quantity, p
45
CFA Level I Study Session 5.1F

• The Supply of and Demand for Productive Resources

46
Markets for Resources

• describe and explain the relationship between the
  price of a resource and the quantity demanded of
  that resource
• The demand for a resource is a derived demand,
  in that the demand for the resource arises
  indirectly from the demand for goods that that
  resource helps to produce.
• As the price of a resource rises, producers using
  that resource respond in two ways
• they substitute towards other resources that are
  less expensive and
• they pass on the higher price of the resource as
  higher prices and reduced quantities of the goods
  being produced using the resource.
• Both produce an inverse relationship between the
  price of the resources and the quantity of the
  resource demanded
• Demand curve for Resource is downward-sloping in
  resources price.

47
Markets for Resources

• identify and describe the influence of three
  factors that cause shifts in the demand curve for
  a resource
• The three factors that cause shifts in the demand
  curve for a resource are
• i) A change in the demand for a product will
  cause a similar change in the demand for the
  resource used in the production of that product.
• ii) Changes in the productivity of the resource
  will alter the demand for that resource. An
  increase in the productivity of a resource will
  increase its demand because this makes the
  resource cheaper per unit of output it produces.
• iii) Changes in the price of a related resource
  will alter the demand for the original resource.
  A rise in the price of a related resource that is
  complementary in production to the original
  resource will cause the demand for the original
  resource to fall. A rise in the price of a
  related resource that is a substitute in
  production to the original resource will cause
  the demand for the original resource to rise.

48
Markets for Resources

• define the marginal revenue product of a resource
  and explain how it influences the demand for that
  resource
• Marginal Revenue Product (MRP) of a resource is
  equal to its marginal product times the selling
  price of the product that it helps to produce.
  The marginal product of a resource is equal to
  the additional units of the good produced by
  using one additional unit of the resource as an
  input in production.
• A profit-maximizing firm will increase their use
  of the resource as long as the marginal cost (MC)
  of the additional unit of the resource is less
  than the resources marginal revenue product.
• Profit is maximized when the level of the
  resource is such that its marginal cost is equal
  to its marginal revenue product.
• MRP MC

49
Markets for Resources

• explain the necessary conditions to achieve the
  cost-minimizing employment levels for two or more
  variable resources
• A profit-maximizing firm with two or more
  variable resources will set the level of
  utilization of each resource so that the MRP of
  that resource is just equal to its Marginal Cost.
  
• MRPj MCj Price of Resource j per unit
• for each resource j 1, 2, 3,
• For each resource, its MRP is the price of the
  final good (P) times the Marginal Product of that
  resource for the output of the final good (MPj).
  
• MRP P x MPj MCj Price of Resource j per
  unit or

50
Markets for Resources

• discuss the factors that influence the supply and
  demand of resources in the short run and long
  run
• In the short-run
• Supply Many resources tend to be fixed in
  amount or relatively immobile across markets.
  This leads to a short-run supply curve that is
  inelastic, i.e. steeply sloping upwards, as
  owners of resources demand higher prices in the
  face of increased short-run demand.
• Demand Adjusting the production process to
  changes in resource prices is difficult in the
  short-run, thus the short-run demand for
  resources is also likely to be inelastic, i.e.
  steeply sloping downwards.
• In the long-run
• Supply Investment, exploration and
  depreciation allows for greater changes in the
  amount of resources available. Thus the long-run
  supply curve tends to be more elastic, i.e. less
  steeply sloped upwards, than the short-run supply
  curve for the resource.
• Demand Adjusting the production process to
  changes in resource prices is easier in the
  long-run, thus the long-run demand for resources
  is also likely to be more elastic, i.e. less
  steeply sloped downwards than short run demand.

51
Markets for Resources

• explain how prices for resources are determined
  in a market economy
• In a market economy the equilibrium price of a
  resource is the level that equilibrates demand
  and supply. If there is an excess supply of the
  resource at a given market price, then the
  unemployed resources will place downward pressure
  on the market price, bringing demand and supply
  back into equilibrium.
• explain the process through which changing
  resource prices influence resource utilization
  and the performance of the economic system.
• Changes in the price of a resource influence the
  behavior of both its users and its suppliers.
  When the price of a resource rises, users will
  search for ways to economize on the use of the
  resource and they may also switch to resources
  that are substitutes in the production process.
  Higher prices will lead suppliers of the resource
  to look for ways to increase the supply of the
  resource through additional investment and
  exploration. It is likely new supply will take
  some period of time to reach the market.

52
CFA Level I Study Session 5.2All New for
2004

• The Financial Environment Markets, Institutions,
  and Interest Rates

53
Capital Markets

• identify and explain the factors that influence
  the supply and demand for capital
• Supply of Capital from savers in the economy is
  influenced by the following factors
• Time Preferences for consumption high rate of
  time preference indicate that current consumption
  is highly valued relative to future consumption.
  This leads to a lower supply of capital from
  savers.
• Risk Higher levels of risk in lending mean less
  capital will be supplied for any given rate of
  return.
• Inflation Higher expected inflation leads savers
  to require higher rates of return to offset the
  effects of inflation on the purchasing power of
  money.
• Demand for Capital is influenced by the following
  factors
• Production Opportunities The more productive the
  projects financed by the borrowed savings, the
  higher the rate of return borrowers will be
  willing to pay to secure the financing.

54
Interest Rates in Capital Markets

• describe the role of interest rates in allocating
  capital
• Firms with the more profitable projects to
  finance will bid away capital from firms with
  less profitable projects. Thus interest rates in
  capital markets ensure that scarce capital made
  available by savers finances the most profitable
  projects in the economy.
• explain how the supply of and demand for funds
  determine interest rates
• Interest rates are the rental price of capital
  determined by demand and supply in the capital
  markets.
• discuss the factors that cause the supply and
  demand curves for funds to shift
• Supply and demand curves in a capital market
  shift if with changes in any of the fundamental
  factors in LOS 2.1.a.
• Capital markets are also interdependent, thus a
  change in demand or supply in one market is
  likely to spill over into affecting demand or
  supply in related capital markets.

55
Real versus Nominal Rates

• distinguish between the real and nominal
  risk-free rate of interest
• Real risk-free rate of interest, k
• The interest rate earned on a riskless security
  if no inflation were expected or the rate of
  interest on a riskless security measured in terms
  of purchasing power.
• Generally taken to be the interest rate on a
  short-term US Treasury security in an
  inflation-free world.
• Nominal risk-free rate of interest, kRF k IP
• The interest rate earned on a riskless security
  whose return is indexed to expected inflation
  such as a short-term indexed US Treasury
  security.
• IP is termed the inflation premium which is equal
  to the average expected inflation over the life
  of the security.

56
Inflation and Interest Rates

• explain the effect of inflation on the real rate
  of return earned by financial securities and by
  physical assets
• Returns on most financial securities are set in
  nominal terms, i.e. money terms, rather than
  purchasing power.
• For given nominal return, higher inflation
  reduces real return on financial asset.
• Returns on physical assets, are less affected by
  inflation
• Prices of the goods or services produced by the
  physical assets rise with inflation, reducing or
  eliminating changes in the real returns.
• define the inflation premium and describe how the
  inflation premium is determined
• Inflation premium
• Determined as the average rate of inflation
  expected over the life of the security under
  consideration. The inflation premium may thus
  vary across assets with different maturities.
• Calculated using inflation rates expected over
  the future, not the rate experienced in the past.

57
Risk Premia in Interest Rates

• describe the default risk, liquidity, and
  maturity risk premiums
• Default Risk premium
• Default risk is the risk that the borrower will
  default on their loan, i.e. not repay interest or
  principal on the loan.
• Calculated as the difference between the interest
  rates on a US Treasury security and a corporate
  bond of equal maturity and marketability.
• Liquidity premium
• Liquidity risk is the risk that the security
  cannot be converted quickly to cash at a fair
  market value. Associated with the marketability
  of the security and the efficiency of the market.
• Calculated as difference between the interest
  rates on two securities of equal maturity and
  risk.
• Maturity Risk premium
• Maturity risk premium is related to the increased
  exposure of long-term securities to both interest
  rate and reinvestment risk.
• Calculated as the difference between interest
  rate on two securities of equal risk and
  marketability. Often calculated using US Treasury
  securities to control default risk.

58
Risk Premia in Interest Rates

• explain interest rate risk and reinvestment rate
  risk.
• Interest Rate Risk
• The prices of long maturity bonds are more
  sensitive to changes in interest rates than those
  of shorter maturity bonds. A rise in interest
  rates causes a greater decline in the value of
  longer maturity bonds.
• Reinvestment Rate Risk
• Shorter maturity bonds are sensitive to changes
  in interest rates when the lenders time horizon
  is longer than the maturity of the bond. Shorter
  maturity bonds must then be reinvested, and thus
  a fall in interest rates will result in a decline
  in interest income when the bonds are reinvested
  at the lower rates.