Introduction to the economics of financial markets PDF
Preview Introduction to the economics of financial markets
Introduction to the Economics of Financial Markets This page intentionally left blank Introduction to the Economics of Financial Markets James Bradfield 1 2007 1 Oxford University Press, Inc., publishes works that further Oxford University’s objective of excellence in research, scholarship, and education. Oxford New York Auckland Cape Town Dar es Salaam Hong Kong Karachi Kuala Lumpur Madrid Melbourne Mexico City Nairobi New Delhi Shanghai Taipei Toronto With offices in Argentina Austria Brazil Chile Czech Republic France Greece Guatemala Hungary Italy Japan Poland Portugal Singapore South Korea Switzerland Thailand Turkey Ukraine Vietnam Copyright © 2007 by Oxford University Press Published by Oxford University Press, Inc. 198 Madison Avenue, New York, New York 10016 www.oup.com Oxford is a registered trademark of Oxford University Press All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior permission of Oxford University Press. Library of Congress Cataloging-in-Publication Data Bradfield, James. Introduction to the economics of financial markets / James Bradfield. p. cm. Includes bibliographical references and index. ISBN-13 978-0-19-531063-4 ISBN 0-19-531063-2 1. Finance. 2. Capital market. I. Title. HG173.B67 2007 332—dc22 2006011610 9 8 7 6 5 4 3 2 1 Printed in the United State of America on acid-free paper To my wife, Alice, to our children, and to their children To the memory of Professor Edward Zabel, a friend and mentor, who taught me the importance of extracting the economic interpretations from the mathematics, and who taught me much more. This page intentionally left blank Acknowledgments My greatest debt is to my wife, Alice, whose encouragement, understanding, and clear thinking about choices are indefatigable. Most 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 drawn this book. Several of those students read many drafts of the book, eliminated errors, and made valuable suggestions for additional examples and for clarity of exposition. I thank John Balio, Tierney Boisvert, Katherine E. Brogan, Matt Clausen, Mike Coffey, Kaitie Donovan, Matt Drescher, John Durland, Schuyler Gellatly, Young Han, Tom Heacock, Jason Hong, Danielle Levine, Brendan Mahoney, Abhishek Maity, Katie Nedrow, Quang Nguyen, Greg Noel, Cy Philbrick, Brad Polan, Eric Reile, Dan Rubin, Katie Sarris, Kevin St. John, Gregory Scott, Joseph P. H. Sullivan, and Kimberly Walker. I appreciate the work of Rachael Arnold, who used her skills as a graphic artist to create computerized drawings of the several figures. I thank Dawn Woodward for the numerous times that she assisted me with the arcana of word processing, and for many other instances of secretarial assistance. Five former students served (seriatim) as editorial and research assistants. I am grateful to Mo Berkowitz, Jon Farber, Gregory H. Jaske, Kathleen McGrory, and Mac Weiss for their industriousness, their intelligence, and their constant good cheer. Each of them contributed significantly to this book. I extend appreciation especially to Dr. Janette S. Albrecht, who watched the progress of this book through periods of turbulence, and who added several dimen- sions to my understanding of sunk costs. Mrs. Ann Burns, a friend of long standing from my days in the dean’s office, cheerfully, speedily, and accurately typed numerous drafts of the manuscript, many of which I wrote by hand, with labyrinthian notes (in multiple colors) in the margins and on the back sides of preceding and succeeding pages. I wish Ann and her family well. I thank Mike Mercier for his editorial encouragement and guidance during an earlier incarnation of this book. My friend and colleague, Professor of English George H. Bahlke, who is an expert on twentieth-century British literature, helped me to maintain a greater meas- ure of equanimity than I would have had without his support. I am also indebted to my friend and colleague, Professor of History Robert L. Paquette, who has written extensively on the Atlantic slave trade, and with whom viii Acknowledgments I teach a seminar on property rights and the rise of the modern 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 I 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. Preface This book is an introductory exposition of the way in which economists analyze how, and how well, financial markets organize the intertemporal allocation of scarce resources. The central theme is that the function of a system of financial markets is to enable consumers, investors, and managers of firms to effect mutually beneficial intertemporal exchanges. I use the standard concept of economic efficiency (Pareto optimality) to assess the efficacy of the financial markets. I present an intuitive devel- opment of the primary theoretical and empirical models that economists use to analyze financial markets. I then use these models to discuss implications for public policy. The book presents the economicsof financial markets; it is not a text in corporate finance, managerial finance, or investments in the usual senses of those terms. The relationship between a course for which this book is written, and courses in corporate finance and investments, is analogous to the relationship between a standard course in microeconomics and a course in managerial economics. I emphasize concrete, intuitive interpretations of the economic analysis. My objective is to enable students to recognize how the theoretical and empirical results that economists have established for financial markets are built on the central eco- nomic principles of equilibrium in competitive markets, opportunity costs, diversifi- cation, arbitrage, and trade-offs between risk and expected return. I develop carefully the logic that supports and organizes these results, leaving the derivation of rigorous proofs from first principles to advanced texts. (Some proofs and technical extensions are presented in appendices to some of the chapters.) Students who use this text will acquire an understanding of the economics of financial markets that will enable them to read with some sophistication articles in the public press about financial markets and about public policy toward those markets. Dedicated readers will be able to understand the central issues and the results (if not the technical methods) in the schol- arly literature. I address the book primarily to undergraduate students. The selection and presen- tation of topics reflect the author’s long experience teaching in the Department of Economics at Hamilton College. Undergraduate and beginning graduate students in programs of business administration who want an understanding of how economists assess financial markets against the criteria of allocative and informational efficiency will also find this book useful.
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