Introduction to the economics of financial markets

IN TRODUCTION

to the E c o n o m ic s

o f F i n a n c i a l M a r k e t s

Introduction to the Economics of

Financial Markets

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Introduction to the

Economics of Financial

Markets

James Bradfield

OXTORD

U N I V E R S IT Y P R E S S

2007

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Library o f C ongress Cataloging-in-Publication Data

Bradfield, James.

Introduction to the econom ics o f financial m arkets / Jam es Bradfield.

p. cm.

Includes bibliographical references and index.

ISBN-13 978-0-19-531063-4

ISBN 0-19-531063-2

1. Finance. 2. Capital m arket. I. Title.

HG173.B67 2007

332—dc22 2006011610

M X 7 ft 5 4 3 2 I

Printed in the United Stale of A merica

on acid-free paper

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To my wife, Alice, to our children, and to their children

To the memory o f Professor Edward Zabel,

a friend and mentor, who taught me the importance o f

extracting the economic interpretations from

the mathematics, and who taught me much more.

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Preface

This book is an introductory exposition of the way in which econom ists analyze how,

and how well, financial markets organize the intertem poral allocation o f scarce

resources. The central theme is that the function of a system o f financial markets is to

enable consum ers, investors, and m anagers of firms to effect m utually beneficial

intertem poral exchanges. I use the standard concept o f econom ic efficiency (Pareto

optim ality) to assess the efficacy o f the financial markets. I present an intuitive devel￾opm ent o f the prim ary theoretical and em pirical models that econom ists use to analyze

financial m arkets. I then use these m odels to discuss im plications for public policy.

T he book presents the econom ics o f financial m arkets; it is not a text in corporate

finance, m anagerial finance, or investm ents in the usual senses o f those term s. The

relationship betw een a course for w hich this book is w ritten, and courses in corporate

finance and investm ents, is analogous to the relationship betw een a standard course in

m icroeconom ics and a course in m anagerial econom ics.

I em phasize concrete, intuitive interpretations o f the econom ic analysis. M y

objective is to enable students to recognize how the theoretical and em pirical results

that econom ists have established for financial m arkets are built on the central eco￾nom ic principles o f equilibrium in com petitive m arkets, opportunity costs, diversifi￾cation, arbitrage, and trade-offs betw een risk and expected return. I develop carefully

the logic that supports and organizes these results, leaving the derivation o f rigorous

proofs from first principles to advanced texts. (Som e proofs and technical extensions

are presented in appendices to som e of the chapters.) Students who use this text will

acquire an understanding o f the econom ics o f financial m arkets that will enable them

to read w ith som e sophistication articles in the public press about financial m arkets

and about public policy tow ard those m arkets. D edicated readers will be able to

understand the central issues and the results (if not the technical m ethods) in the schol￾arly literature.

I address the book prim arily to undergraduate students. The selection and presen￾tation o f topics reflect the au th o r’s long experience teaching in the D epartm ent o f

Econom ics at Ham ilton College. U ndergraduate and beginning graduate students in

program s o f business adm inistration who w ant an understanding of how econom ists

assess financial m arkets against the criteria o f allocative and inform ational efficiency

will also find this book useful.

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viii Preface

I have taught mainly in the areas of investments and portfolio theory, and in intro￾ductory and intermediate microeconomic theory. I also teach a course in mathem ati￾cal economics, and I have written (with Jeffrey Baldani and Robert Turner, who are

economists at Colgate University) the text M athematical Economics, second edition

(2005). I recently taught an introductory course and an advanced seminar in m athe￾matical econom ics at Colgate.

Readers of this book should have completed one introductory course in econom ­

ics (preferably microeconomics). Although I use elem entary concepts in probability

and statistics, it is not critical that readers have completed formal courses in these

areas. I present in the text the concepts in probability and statistics that will enable a

student with no previous work in these areas to understand the econom ic analysis.

Students who have completed an introductory course in probability and statistics will

be able to understand the exposition in the text more easily. I use graphs extensively,

and I assume that students understand the solution of pairs of linear equations.

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Acknowledgments

M y greatest debt is to my wife. Alice, whose encouragem ent, understanding, and clear

thinking about choices are indefatigable.

M ost professors owe much to their students; I am no exception. I have learned

much from the students who have taken the courses from which I have draw n this book.

Several o f those students read many drafts of the book, elim inated errors, and made

valuable suggestions for additional exam ples and for clarity o f exposition. I thank John

Balio, Tierney Boisvert, K atherine E. Brogan, M att Clausen, M ike Coffey, Kaitie

D onovan, M att Drescher. John Durland, Schuyler Gellatly, Young Han, Tom Heacock,

Jason Hong, Danielle Levine, Brendan M ahoney, A bhishek Maity, Katie Nedrow,

Q uang N guyen, G reg Noel. Cy Philbrick, Brad Polan. Eric Reile, Dan Rubin. Katie

Sarris. K evin St. John. G regory Scott. Joseph P. H. Sullivan, and Kim berly Walker. I

appreciate the work o f Rachael Arnold, who used her skills as a graphic artist to create

com puterized draw ings of the several figures.

1 thank D awn W oodward for the num erous tim es that she assisted me with the

arcana o f w ord processing, and for many other instances o f secretarial assistance.

Five form er students served (seriatim ) as editorial and research assistants. I am

grateful to M o Berkow itz, Jon Farber, G regory H. Jaske, K athleen M cGrory, and M ac

W eiss for their industriousness, their intelligence, and their constant good cheer. Each

o f them contributed significantly to this book.

I extend appreciation especially to Dr. Janette S. A lbrecht, who w atched the

progress o f this book through periods o f turbulence, and who added several dim en￾sions to my understanding o f sunk costs.

M rs. Ann B um s, a friend o f long standing from my days in the dean's office,

cheerfully, speedily, and accurately typed num erous drafts o f the m anuscript, many of

w hich I wrote by hand, with labyrinthian notes (in m ultiple colors) in the m argins and

on the back sides o f preceding and succeeding pages. I wish Ann and her fam ily well.

I thank M ike M ercier for his editorial encouragem ent and guidance during an

earlier incarnation of this book.

M y friend and colleague. Professor o f English George H. B ahlke, w ho is an

expert on tw entieth-century British literature, helped me to m aintain a greater m eas￾ure o f equanim ity than I w ould have had w ithout his support.

I am also indebted to my friend and colleague. Professor o f History Robert L.

Paquette, who has w ritten extensively on the Atlantic slave trade, and with whom

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Acknowledgments

I teach a seminar on property rights and the rise of the modem state. Among other valu￾able lessons, Professor Paquette reminded me on several occasions that the application

of theoretical models in economics is limited by the prejudices of the persons whose

behavior we are trying to explain.

I appreciate the confidence that Terry Vaughn, Executive Editor at Oxford

University Press, expressed in my work, which culminated in this book. Catherine

Rae, the assistant to Mr. Vaughn, helped me in numerous ways as 1 responded to

referees’ suggestions and prepared the manuscript. Stephania Attia, the Production

Editor for this book, supervised the compositing closely, and I thank her for doing so.

I also appreciate the attention to detail provided by Jean Blackburn of Bytheway

Publishing Services. Judith Kip, a professional indexer, contributed significantly by

constructing the index.

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Contents

Part I Introduction

1 The E conom ics o f Financial M arkets

1.1 The Econom ic Function o f a Financial M arket

1.2 The Intended R eaders for T his Book

1.3 Three K inds o f Trade-Offs

1.4 M utually B eneficial Intertem poral Exchanges

1.5 Econom ic Efficiency and M utually B eneficial Exchanges

1.6 Exam ples of M arket Failures

1.7 Issues in Public Policy

1.8 The Plan o f the Book

Problem s

Notes

3

3

3

5

8

11

14

14

16

16

2 Financial M arkets and E conom ic Efficiency

2.1 Financial Securities

2.2 Transaction C osts

2.3 Liquidity

2.4 The Problem o f A sym m etric Inform ation

2.5 The Problem o f A gency

2.6 Financial M arkets and Inform ational Efficiency

Problem s

Notes

19

19

26

26

29

36

38

41

42

Part'll - Intertem poral Allocation by Consumers and Firms When

Future Payments Are Certain

3 The Fundam ental Econom ics o f In te rte m p o ra l A llo cation

3.1 The Plan o f the C hapter

3.2 A Prim itive Econom y w ith N o Trading

47

47

47

xi

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