Lecture 10 With Lecture Notes

Market Imperfections

(Welch, Chapter 10)

Oleg Shibanov

New Economic School

March, 2014

Did you bring your calculator? Did you read the chapter ahead of time?

Oleg Shibanov (NES) Market Imperfections March, 2014 1 / 34

Maintained Assumptions

In this chapter, we relax the one remaining assumption:

I We no longer assume perfect markets.) We can now have dierences in opinion, taxes, transaction costs, or bigsellers/buyers.

I With this chapter, we are actually completing all basic topics.

I Everything else will be (thick) gravy that elaborates on the details.


How perfect is the market for PepsiCo shares?

Judge:

I Opinions: modestly dierent. Derived opinions must be reasonably close.

I Substitutability of product, buyers, sellers: pretty close

I Transaction costs: low, unless you need to short great amounts.

I Taxes: depends on the seller's and your tax status.


In a perfect market, is the quoted borrowing rate equal tothe quoted savings (lending) rate?


In a perfect market, is the expected borrowing rate equalto the expected savings (lending) rate?


What happens to borrowing and lending interest rates ifeverybody does not share the same information/opinion?

Market imperfections can render the borrowing rate higher than the savings(lending) rate.

For example

I The lender may believe a startup project is no good and demand 50%,expecting to get only 25%.

I The entrepreneur himself may believe the startup project is great and think25% is fair. He may believe that the lender would get an expected rate ofreturn of 50% at the lender's quoted rate.

I Who is right ex-ante? (Usually the pessimist, i.e., the bank.)


What happens to borrowing and lending interest rates ifthere is only one seller (bank)? Or if there is only onebuyer (rm borrowing)?

A sole bank will exploit the monopoly power by asking for higher loan rates andlower investment rates.

No investor, lender, or product must be unique. No investor plays a dierent role.Investors are substitutable for one another. Or, there are many plenty of each type.

Note that this assumption also makes sure that you get nothing from waiting foranother buyer. There is an innite number of buyers already present.


What happens to borrowing and lending interest rates ifthere are transaction costs to lending?

To administer a loan, the bank must charge a higher interest to recover itsoperating costs, too. So, the lending rate is again lower than the borrowing rate.

Note that the current holder may be better o not selling because the transactioncost penalty may eat up too much. Thus, it becomes more valuable for thecurrent owner to stay the owner.


What happens to borrowing and lending interest rates ifthere are taxes?

This can be like a transaction cost, but accruing to the government.

Note that the current holder may be better o not selling because the tax penaltyaccrues to him/her. Thus, it becomes more valuable for the current owner to staythe owner.


What happens to borrowing and lending interest rates ifthere is ination?

NOTHING.

Ination is not a market imperfection, so the borrowing and lending rates mayboth be higher in the presence of ination, but there will be no extra wedge here.

HOWEVER, higher unexpected ination usually means more volatile ination, andthus borrowing rates may increase more than lending rates because the bankconsiders ination as a friction.

(Note: ination targeting by Central Banks)


Generically, what can happen to borrowing and lendinginterest rates if the nancial market is not perfect?

Borrowing rates usually become higher than lending (savings) rates. They are nolonger assured to be the same.

These assumptions may be overkill, but they are denitely sucient. Wesometimes lean heavily on one or all of them; sometimes we don't need to lean onone or the other|or even most of them|very heavily.


In a perfect market, can the value of an object depend onits owner?


In an imperfect market, can the value of an object dependon its owner?

Yes. As the current owner, you may be better o staying the owner, because theproject is worth more to you than it is to the potential buyers.

An example follows.


Example: A project costs $950 and returns $1,000. Whatis the project's expected rate of return?

$1; 000=$950 1 5:3%


If the market were perfect, what would you do if theeconomy-wide cost of capital E (r) were 10%?


If the market were perfect, what would you do if theeconomy-wide cost of capital E (r) were 1%?


What should you do if your project costs $950 and returns$1,000; and if your alternative investment opportunitiesprovide you with a rate of return E (r) of 1%, but yourcost of capital is 10%?


What is the value of this project?

There is no unique value anymore. The project value now depends on your wealth.It could be anything between $1; 000=1:01 = $990:10 and$1; 000=1:10 = $909:09, depending on how much money you have.


The Plague (Consequence #2)

I The project value is no longer unique. It depends on whether you havemoney or not|i.e., the project value depends on who you are.I If you have no money, the project is worth $1; 000=1:10 $909.I If you have a ton of money, the project is worth $1; 000=1:01 $990.I If you have between $0 and $950 in wealth, the project is worth somewhere

between $909 and $990.).

I Dependence of project value on who owns it is what we tried to avoid|likethe plague.I If project value depends on who owns it, then what can nance tell you about

the world? That projects cost whatever they may cost?


What Perfect Markets Bought Us

I Identical interest rates (perfect markets) mean that project values do notdepend on how much wealth the project owners have.

I Identical interest rates (perfect market) guarantee that there is a uniqueproject value, at which the project can be bought or sold. Otherwise, projectscan take on a range of feasible values.

I Strictly speaking, with one exception (tax-adjustment formulas), everyformula in nance has been derived and is known to work, only in perfectmarkets.

I Think of perfect-market assumptions as the equivalent of assuming thatacceleration in freefall is at a rate of 9.81 m/s2. Actually, this is never actuallytrue, either{it is just an approximation. For some purposes, it is good enough.For others, it is not. You must be the judge in your own application.

I Market imperfections are at the core of Entrepreneurial Finance. Small,privately held rms do not face near-perfect nancial markets, the same waythat large, publicly traded rms do.


Is the value of an object always its price (what you can sellthe object for)?


What is one key underlying concept in determining howmuch you should trust a valuation? What should you askyourself?

It is not \is this market perfect" but \to what extent is this market perfect?"


Are the following markets perfect? How unique is theproject value to its holder?

I Municipal Securities?

I Houses?

I Jewelry?

I Airline Tickets?

I Funeral Services?

I Children?

I Marriage?

I Engagement rings?


If there is no deal, isn't this bad news for buyers andsellers?

No, it is not bad news. You can talk about buyer and seller surplus! Perhapsdiscuss \infra-marginal". I like the example of being able to buy gas when you runout of it and value it at $10/litre.

The social value and surplus from trading in a perfect market is not zero.


Opinions and Disagreements

I Without uncertainty, there are no information dierences.

I With uncertainty, there need not be information dierences.

I With uncertainty, in the real world, rms with a lot of uncertainty tend tosuerI higher default premium (not expected! perfect mkt)I payment of more risk premium (though mild for bonds). (perfect mkt)I imperfect market premia: information premium here.I imperfect market premia: X-costs and liquidity premiumI (maybe even specic skills/buyers: market premium.)

I Small rms suer a full syndrome, not just one symptom ) Dicult to sortout real-world spreads into determinants.

I Market imperfections can create higher/dierential expected rates of return,like risk-aversion, too. The default premium does not.


Opinions and Disagreements II

Do not confuse this (imperfect-market) discussion about dierences in expectedrates with (perfect-market) dierences in promised rates.

I For example, almost all entrepreneurs believe that they will succeed|anopinion. But they are also overcondent, and thus objectively often bad risks.The fact that they have to pay higher quoted (promised) costs of capital thusmay often reect default risk, not just market imperfections.

I Most of the yield spread of corporate bonds is due to higher defaultprobability.I For example, Boston Celtics = 9.4%, whereas Treasury = 5.6%. The 3.8%

dierence is not primarily an expected rate of return that is higher. On average(over many rms like the Celtics), such bonds will probably pay around 6%.


What mechanisms can mitigate the disagreement marketimperfection?

Loan Covenants. Collateral. Credit Ratings. CDS.

Large corporations have credit ratings, too, from AAA (best) to F.

I AAA rms had 0% probability of default (one non-payment) over 5-10years.

I B rms had 20% probability of default.

I C rm had a 50% probability of default.

Covenants and Collateral | mechanisms to let each party that is more optimistictake more of each part of the risk.


Transaction Costs

I Try to think of roundtrip transaction costs.

I When you buy a house, the seller pays the realtor agents a commission,nowadays about 5% of the value of the house. (There is another 1% invarious transaction costs.)

I This does not mean that, as a buyer, you are not implicitly paying for this,too. If the seller did not have to pay this commission, the seller would accepta lower price.

I In terms of value-at-risk, i.e., as a fraction of the equity that is your own givenstandard 80% nancing, this transaction cost eats up more than 25% of yourequity investment the moment you close.


What does it cost to sell a $1 million in PepsiCo shares?

Direct costs may be around 20 basis points on well-executed orders that trade $1million in a liquid stock like PepsiCo, including the price impact. The indirectcosts are often trivial, too|maybe $20.

You can think of this $1 million as just the equity portion. PepsiCo carries loans,just like your house does.


How do you take care of transaction costs in NPV?

They are easy to take care of in NPV. Just do everything post-transactioncosts|both expected cash ows, and your opportunity cost of capital (returnfrom investing elsewhere).


What is a liquidity premium?

Liquidity Premium: An extra expected rate of return to induce you to holdsomething that will be tough to resell if/when you are in a hurry.

I Strangely, the liquidity premium, which should be of second orderimportance, seems to be very important. Witness for example the Russiancrisis or LTCM. The liquidity premium seems to have a strong interactionwith economy-wide nancial slack and aggregate borrowing.

I Perhaps most money on WS comes from liquidity provision. (Same forwholesalers and ordinary retail stores.)

I If you run a fund, make some of your money through liquidity provision|butdo not go overboard, or you will end up bankrupt.


Can the real rate of return on a bond be negative?


Can the real after-tax rate of return on a bond benegative?


Lecture 10 With Lecture Notes

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