Learning Unit #10: Demand For Assets

1. Learning Unit #10
Demand for Assets

2. Objectives of Learning Unit #10
This unit and the next introduce the
standard demand-supply model of asset
markets. This unit focuses on the
demand:
• Market of Financial Instruments
• Determinants of Asset Demand
• Concept and Measurement of Risk & Return
• Importance of Expectations

3. Markets of Financial Assets
• To analyze financial markets and how prices of
financial instruments are determined in financial
markets, we are primarily looking at primary
markets where saver/lenders interact with
borrower/spenders.
Primary
Financial
Markets
Savers
Lenders
Borrowers
Spenders
IOUIOU

4. Demanders and Suppliers of
Financial Assets
• In the primary markets, buyers of financial instruments
are ones investing on and demanding financial
instruments, while sellers of financial instruments are
ones issuing (producing) and supplying financial
instruments.
• Demanders of financial instruments: By purchasing
financial instruments, they are providing funds.
– Demanders of financial assets are savers/lenders.
• Suppliers of financial instruments: By issuing financial
instruments, they are borrowing funds.
– Suppliers of financial assets are borrower/spemders.

5. Quick Review of Demand
It is extremely important to distinguish terms
“quantity demanded” and “demand.”
• Quantity demanded: An amount (quantity) of financial
instruments that saver/lenders are willing to purchase
for a given conditions (i.e. price, income, risk)
− Quantity demanded is a particular number.
• Demand: A relationship between the price of financial
assets and the quantity demanded, holding all other
determinants of quantity demanded constant.
− Demand is represented by a table of numbers, or a
curve on diagram, or a mathematical function.

6. Examples of Quantity demanded
and Demand
• Quantity demanded: If you earn $50,000, and if
a price of Google stock is $200, then you may
want to purchase 5 units of Google stock.
Quantity demanded is “5 units”.
• Demand: Given $50,000 income, you may
purchase numbers of Google stock depending
on its price.
Demand is “1 unit at $500, 5 units at $200, 10
units at $100,...”

7. What Affects Your Quantity
Demanded for Financial Assets?
What may make you willing to buy more or
less of Google stocks?
• How much wealth and income do you have (do
you have spare cash now to buy Google
stocks)?
• How much profits do you expect to make from
Google stocks?
• Which one do you like to have, Google stock,
Exxon stocks, or Treasury bond?
• What else?

8. Determinants of Quantity
Demanded for Financial Assets
There are many factors affecting quantity
demanded for a particular financial asset.
• Wealth and income
• Liquidity
• Expected return
• Risk
• Liquidity, expected return, and risk of other
financial assets
• Expectation

9. Determinants of Quantity
Demanded for Financial Assets
Among six determinants of quantity demanded for
financial assets,
• Wealth and income are specific to a particular buyer
(saver/lender).
• Liquidity, Expected return, & Risk are specific to a
particular financial asset.
• Liquidity, expected return, and risk of other financial
assets include all alternative saving opportunities.
• Expectations on all above – your future income, liquidity
& risk of a particular financial asset and all other
financial assets in future.

10. Wealth and Income of Saver
• When your wealth and income increase, you are
more likely to purchase financial assets.
– Can you afford to buy one Google stock at $600?
Maybe not now. If you win mega-million lottery, then
will you buy Google stocks? maybe.
• Wealth of saver ↑
⇒ Quantity demanded for any financial assets ↑

11. Income of All Savers
• Quantity demanded for financial assets in the financial
market is sum of all quantity demanded by all savers in
the market.
• Even if you just got a job and started to make more
income (lead to more quantity demanded for financial
assets), others may have lost incomes (lead to less
quantity demanded for financial assets), so in sum the
quantity demanded for financial assets may decrease.
• It is important to see overall changes in income and
wealth of all saver/lenders to figure out an effect on
demand for financial assets in market.
• National income is one measurement of overall income
in the U.S., or Disposable income is a measurement of
how much all households in the U.S. can spend or save.
– Check Learning Unit 1 for these definitions.

12. Liquidity of Asset
• Liquidity is how easily or quickly a financial
asset can be sold.
• In general, saver/lenders prefer financial assets
with high liquidity (liquid assets) over others with
low liquidity (illiquid assets).
– If you have an extra fund now, will you use it to
purchase three-year CD or simply deposit it in your
checking account.
• Liquidity of an asset ↑
⇒ Quantity demanded for the asset ↑

13. Price or Rate of Return on Asset
• For goods and services, a price of good is the most important
determinant of quantity demanded, because a consumer makes a
decision by comparing the price of the good with benefit that a
consumer can get from the good.
– Is 8GB iPod Nano worth $200 for you? If yes, then you should purchase it
at $200, otherwise you shouldn’t.
• For financial assets, you do not consume them, instead you gain by
selling them later (or simply receiving future cash flows). So, the price
of financial asset today is as important as the price of the financial
asset when you sell it, and both of them affect your quantity
demanded for financial assets.
– Should you buy Google stock at $800? It depends. If you expect its price
to go up to $900, then you should. On the other hand, if you expect its
price to go down to $780, then you should not.
• Instead of price of financial assets, a rate of return or interest rate is
more relevant determinant of quantity demanded for financial assets.

14. Expected Return of Asset
• In most cases, you do not know exactly how much rate
of return you will get from any financial assets (unless
you hold it until its maturity).
• There is a chance that you may get a high rate of return,
and a chance that you may get even a negative rate of
return.
• So, you have to make a best guess on rate of return
from any financial asset. The best guess in finance and
economics in this case is called “Expected return.”
• Expected Return: Mean (Average) rate of return or
interest rate.

15. Expected Return and Quantity
Demanded
• In general, people prefer a higher rate of return
than a lower rate of return, holding all other
determinants (such as risk and liquidity)
constant.
– If Bank of America offers 3% interest rate on a
checking account while Wachovia Bank offers 0%
interest rate on a checking account, which bank will
you open your checking account?
• Expected return of an asset ↑
⇒ Quantity demanded for the asset ↑

16. How to Measure Expected Return
• Expected return is an average of all possible
rates of return.
• Formula: Re
=Σpi x Ri
Re
: Expected return
pi: Probability of an event i
Ri: Rate of return if an event i occurs.

17. Example of Measuring Expected
Return
The U.S. economy may become better or worse.
A probability of a better economy is 0.75, while a
probability of a worsened economy is 0.25. If the
U.S. economy is better, the rate of return on IBM
stock will be 60%. If the U.S. economy worsens,
the rate of return on IBM stock will be -20%. How
much is an expected return on the IBM stock?
Re
= (0.75)(+60%) + (0.25)(-20%) = 40%

18. Expected Return and Actual Return
• Since an expected return is a weighted average
of possible rates of returns, a saver will never
have the “expected” return in reality. An actual
rate of return will be one of all possible rates of
returns.
– It is like a student’s average test score. If she had
80, 98, 76, and 84, her average test score is 84.5. Of
course, she never made 84.5 point on any of her
tests.
– However, like average test score, a saver prefer
higher expected return than a lower expected return.
• On the previous example, no one will actually
get 40% rate of return, every one get either
60% or -20%.

19. Risk
• A term “risk” is often used as “having something
bad or likely to have something bad.” However,
in finance and economics, the term “risk” has a
special meaning.
• Risk: Uncertainty of actual total rate of return
• It does not matter whether bad thing to happen
or not, as long as you do not know the outcome
exactly, then there is a risk. It does not matter
whether it costs you or not.

20. Examples of Risk
• You got a stock free which is currently priced at $0. The price of
stock may become $0 or possibly $5 next year.
– Although it does not cost you to get a stock and you will never
loose from the stock, there is a risk on return from this stock since
you do not know whether you get $0 or $5 next year.
• You paid $10 to purchase a bankrupted Enron stock (the company no
longer exists, so no one will buy it from you).
– Although you surely loose $10 from this investment (-100% rate of
return), there is no risk because it is certain to loose.
• A student studies very hard on a test, so he can make at least B on
the test.
– There is a risk since he does not know whether he will make B or
A (and, of course, possibly C).
• A student misses a test with full understanding that a missing test will
result in F grade.
– No risk since she is surely to get F.

21. Risk and Quantity Demanded
• In general, a saver does not like risk (risk-averse).
– Of course, some people get shrilled on taking risk like
buying lottery tickets. But, are you willing to put all of
your saving and income to purchase Mega-million lottery
tickets?
– If you can get a same expected return (5%), which one
will you choose, 1 year CD with 5% interest rate (certain)
or loaning funds to a stranger for one year with 5%
expected return?
• Risk of an asset ↑
⇒ Quantity demanded for the asset ↓

22. Measuring Risk
• In economics and finance, risk is measured by a
standard deviation of rate of return.
• A standard deviation will tell you how likely you can
get an actual return close to an expected return.
– If a standard deviation is zero, then you will get the
expected return surely.
– If a standard deviation is large, then you may get more
likely an actually return far from the expected return,
possibly much more or much less than the expected
return.
• Check your statistics book for calculation of
standard deviation.

23. Three Types of Risk
There are many types (more than ten types) of
risk in finance. Here I present three types of risk
related to Money & Banking.
Default risk: A borrower may not pay the interest or the
principal.
Purchasing power risk: An actual real rate of return
could be higher or lower than one an investor initially
expected due to inflation.
Interest rate risk: A price of security may change and its
total rate of return when the market interest rate
changes.

24. Default Risk
• When you loan your funds to a stranger, there is a
possibility that a borrower may not pay back you.
• Since any organization has a possibility of
bankruptcy, almost all financial instruments have
default risk.
– Since likelihood of bankruptcy varies from one firm to
another, default risk also varies among borrowers.
• However, U.S. Treasury securities and any
securities backed by the U.S. government do not
have default risk.
– U.S. government can pay back always by collecting
more tax or issuing more cash.

25. Purchasing Power Risk
• When you purchase securities, you know how
much dollars (future cash flows) you will get from
the securities and their rates of return (nominal
interest rates).
• However, you do not know how much goods and
service you can purchase from those dollars in
future (the real interest rate).
• Since no one knows exactly a future inflation rate
(even the chairman of Fed), almost all financial
instruments have purchasing power risk.
• However, inflation-indexed bonds do not have
purchasing power risk, since it guarantees a real
interest rate.

26. Interest Rate Risk
• Most savers will not hold securities until their maturities,
instead sell them earlier.
• Savers cannot predict an exact price of security in
future, so the rate of return from the security is
uncertain.
– Although savers know Pt and C on bonds when they purchase
bonds, they do not know Pt+1.
– R = (C + Pt+1 – Pt)/Pt x 100
• Among many factors affecting the price of security, the
most important factor is the market interest rate.
– An inverse relationship: If the interest rate increases, the price
of bond will decrease and the rate of return will fall.
– Depending on whether the market interest goes up or down, a
rate of return may fall or rise in future.

27. Risk-Return Trade-off
There is a close relationship between rate of
return and risk of security.
• Higher the risk, higher the return.
• Risk premium: The spread between the expected
return from a risky asset and the interest rate of risk-
free asset.
• Lenders do not like risk. In order to make lenders
more willing to lend funds, borrowers with high risk
must pay an extra-return (risk premium) to
compensate such risk.

28. Risk Premium Formula
• Formula: i = if
+ RP
i: Interest rate on a risky asset
if
: Interest rate on a risk-free asset
RP: Risk premium
• In general, we use an interest rate on a comparable
U.S. Treasury securities (same maturity, same
coupon rate, and same characteristics) as the interest
rate on a risk-free asset.
• All other securities have some risk, so as risk
premium.
− Securities with high risk tend to have higher risk
premiums.

29. Example of Risk Premium
• An interest rate on 1-year U.S. Treasury bill is 5%, while
the interest rate on a corporate bond is 20%. How
much is a risk premium of the corporate bond?
• i = 20% on the corporate bond and if
= 5% on T-bill
⇒ 20% = 5% + RP
⇒ RP = 15%
• How much interest rate are you paying on your credit
card (Visa or Master card)? Can you compute a risk
premium on your credit card?

30. Return, Risk & Liquidity of Other
Assets
• Without any changes in savers’ wealth and
income, the amount of saving is fixed.
• If a saver prefers one asset (asset B) more than
others (asset A), then her quantity demanded for
the asset (asset B) will increase, while her
quantity demanded for the other assets (asset
A) will decrease.
• Savers always compare characteristics (liquidity,
expected return, risk) of financial assets and
choose one best for them.

31. Summary of Relationship among
Assets
• Liquidity of an asset B ↑
⇒ Quantity demanded for the asset B ↑
⇒ Quantity demanded for the asset A ↓
• Expect return of an asset B ↑
⇒ Quantity demanded for the asset B ↑
⇒ Quantity demanded for the asset A ↓
• Risk of an asset B ↑
⇒ Quantity demanded for the asset B ↓
⇒ Quantity demanded for the asset A ↑

32. Expectations
• What expected to happen tomorrow will affect the
quantity demanded for an asset today.
• Since savers purchase financial assets for their saving
purposes, their future financial conditions and market
conditions at time they plan to sell them.
– If you expect to loose your job in several months, will you start
saving more (and demanding more financial assets) now for
the rainy days?
– If you expect a bullish stock market (stock prices are expected
to rise continuously), will you buy more stocks now?
– If you expect the market interest to increase soon, should you
buy bonds now?

33. Expectations and Quantity
Demanded for Financial Assets
•Wealth of saver is expected to ↑ near future
⇒ He starts spending more (and less funds available
for saving) now
⇒ Quantity demanded for any assets ↓ now
•Liquidity of an asset is expected to ↑ near future
⇒ It will be easier to sell securities in future
⇒ Quantity demanded for the asset ↑ now

34. Expectations and Quantity
Demanded for Financial Assets
•Return of an asset is expected to ↑ near future
⇒ Saver wants to get a higher return.
⇒ Quantity demanded for the asset ↑ now
•Risk of an asset is expected to ↑ near future
⇒ It will be more uncertain how much return you may
get and possibly loss of return due to higher risk in
future
⇒ Quantity demanded for the asset ↓ now

35. Summary of Asset Demand
Page 90

36. Disclaimer
Please do not copy, modify, or distribute this presentation
without author’s consent.
This presentation was created and owned by
Dr. Ryoichi Sakano
North Carolina A&T State University