2016/9/8 Principles of Pricing Financial Assets Principles of Pricing Financial Assets The market price of an asset equals The appropriate discount rate is equal to r=RR +IP+ DP MP+ LP + EP +r)(+r2(1+r)3(1+r) where: RR the real rate of interest IP =the inflation premium where: P= the price of the financial asset P= the default risk premium CFr cash flow at end of year t(61, 2,N) MP=the maturity premium N= maturity of the financial asset LP the liquidity premium r appropriate discount rate P= the exchange-rate risk premium Role of financial Markets Role of financial markets Intuitively, the financial markets are where we can Should financial markets be issue, buy or sell financial assets. If not, how do you search for potential buyers or Role of financial markets Determine price or required rate of return of asset What is the cost associated? What about the credit risk? Reduce transactions costs which consists of earch costs and information costs Classification of Financial Markets Financial Market Participants Various ways in classifying financial markets Household Sector Debt vs equity markets -Primary Need: Invest Funds Money market vs capital market · Business secto Primary vs secondary market Primary Need: Raise Funds Cash(or spot)vs derivatives market Government sector Over-the-counter vs intermediated market Primary Need: Raise Funds But they can have other needs too2016/9/8 4 0-19 Principles of Pricing Financial Assets • The market price of an asset equals: N N r CF r CF r CF r CF P (1 ) ... (1 ) (1 ) (1 ) 3 3 2 2 1 1          where: P = the price of the financial asset CFt = cash flow at end of year t (t=1,2,…,N) N = maturity of the financial asset r = appropriate discount rate 0-20 Principles of Pricing Financial Assets • The appropriate discount rate is equal to: r = RR + IP + DP + MP + LP + EP where:  RR = the real rate of interest IP = the inflation premium DP = the default risk premium MP = the maturity premium LP = the liquidity premium EP = the exchange‐rate risk premium 0-21 Role of Financial Markets • Intuitively, the financial markets are where we can issue, buy or sell financial assets. • Role of financial markets – Determine price or required rate of return of asset. – Provide liquidity. – Reduce transactions costs, which consists of search costs and information costs. 0-22 Role of Financial Markets • Should financial markets be organized? • If not, how do you search for potential buyers or sellers? • What is the cost associated? • What about the credit risk? Classification of Financial Markets • Various ways in classifying financial markets –Debt vs. equity markets – Money market vs. capital market – Primary vs. secondary market – Cash (or spot) vs. derivatives market –Over‐the‐counter vs. intermediated market 0-23 Financial Market Participants • Household Sector – Primary  Need: Invest Funds • Business Sector – Primary Need: Raise Funds • Government Sector – Primary Need: Raise Funds But they can have other needs too. 0-24