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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?

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Maintained Assumptions

In this chapter, we relax the one remaining assumption:


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We no longer assume perfect markets.


We can now have dierences in opinion, taxes, transaction costs, or big
sellers/buyers.

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

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

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How perfect is the market for PepsiCo shares?

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

Substitutability of product, buyers, sellers: pretty close

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

Taxes: depends on the sellers and your tax status.

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In a perfect market, is the quoted borrowing rate equal to


the quoted savings (lending) rate?

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In a perfect market, is the expected borrowing rate equal


to the expected savings (lending) rate?

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What happens to borrowing and lending interest rates if


everybody does not share the same information/opinion?
Market imperfections can render the borrowing rate higher than the savings
(lending) rate.
For example
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The lender may believe a startup project is no good and demand 50%,
expecting to get only 25%.

The entrepreneur himself may believe the startup project is great and think
25% is fair. He may believe that the lender would get an expected rate of
return of 50% at the lenders quoted rate.

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

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What happens to borrowing and lending interest rates if


there is only one seller (bank)? Or if there is only one
buyer (firm borrowing)?

A sole bank will exploit the monopoly power by asking for higher loan rates and
lower 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 for
another buyer. There is an innite number of buyers already present.

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What happens to borrowing and lending interest rates if


there are transaction costs to lending?

To administer a loan, the bank must charge a higher interest to recover its
operating 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 transaction
cost penalty may eat up too much. Thus, it becomes more valuable for the
current owner to stay the owner.

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What happens to borrowing and lending interest rates if


there 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 penalty
accrues to him/her. Thus, it becomes more valuable for the current owner to stay
the owner.

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What happens to borrowing and lending interest rates if


there is inflation?

NOTHING.
Ination is not a market imperfection, so the borrowing and lending rates may
both be higher in the presence of ination, but there will be no extra wedge here.
HOWEVER, higher unexpected ination usually means more volatile ination, and
thus borrowing rates may increase more than lending rates because the bank
considers ination as a friction.
(Note: ination targeting by Central Banks)

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Generically, what can happen to borrowing and lending


interest rates if the financial market is not perfect?

Borrowing rates usually become higher than lending (savings) rates. They are no
longer assured to be the same.
These assumptions may be overkill, but they are denitely sucient. We
sometimes lean heavily on one or all of them; sometimes we dont need to lean on
one or the otheror even most of themvery heavily.

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In a perfect market, can the value of an object depend on


its owner?

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In an imperfect market, can the value of an object depend


on its owner?

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

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Example: A project costs $950 and returns $1,000. What


is the projects expected rate of return?

$1, 000/$950 1 5.3%

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If the market were perfect, what would you do if the


economy-wide cost of capital E (r ) were 10%?

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If the market were perfect, what would you do if the


economy-wide cost of capital E (r ) were 1%?

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What should you do if your project costs $950 and returns


$1,000; and if your alternative investment opportunities
provide you with a rate of return E (r ) of 1%, but your
cost of capital is 10%?

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What should you do if your project costs $950 and returns


$1,000; and if your alternative investment opportunities
provide you with a rate of return E (r ) of 1%, but your
cost of capital is 10%?

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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.

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The Plague (Consequence #2)

The project value is no longer unique. It depends on whether you have


money or noti.e., the project value depends on who you are.
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If you have no money, the project is worth $1, 000/1.10 $909.


If you have a ton of money, the project is worth $1, 000/1.01 $990.
If you have between $0 and $950 in wealth, the project is worth somewhere
between $909 and $990.).

Dependence of project value on who owns it is what we tried to avoidlike


the plague.
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If project value depends on who owns it, then what can nance tell you about
the world? That projects cost whatever they may cost?

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What Perfect Markets Bought Us


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Identical interest rates (perfect markets) mean that project values do not
depend on how much wealth the project owners have.

Identical interest rates (perfect market) guarantee that there is a unique


project value, at which the project can be bought or sold. Otherwise, projects
can take on a range of feasible values.

Strictly speaking, with one exception (tax-adjustment formulas), every


formula in nance has been derived and is known to work, only in perfect
markets.
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Think of perfect-market assumptions as the equivalent of assuming that


acceleration in freefall is at a rate of 9.81 m/s 2 . Actually, this is never actually
true, eitherit 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.
Market imperfections are at the core of Entrepreneurial Finance. Small,
privately held rms do not face near-perfect nancial markets, the same way
that large, publicly traded rms do.

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

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What is one key underlying concept in determining how


much you should trust a valuation? What should you ask
yourself?

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

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Are the following markets perfect? How unique is the


project value to its holder?
I Municipal Securities?
I Houses?
I Jewelry?
I Airline Tickets?
I Funeral Services?
I Children?
I Marriage?
I Engagement rings?

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If there is no deal, isnt this bad news for buyers and


sellers?

No, it is not bad news. You can talk about buyer and seller surplus! Perhaps
discuss infra-marginal. I like the example of being able to buy gas when you run
out of it and value it at $10/litre.
The social value and surplus from trading in a perfect market is not zero.

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Opinions and Disagreements


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Without uncertainty, there are no information dierences.

With uncertainty, there need not be information dierences.

With uncertainty, in the real world, rms with a lot of uncertainty tend to
suer
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higher default premium (not expected! perfect mkt)


payment of more risk premium (though mild for bonds). (perfect mkt)
imperfect market premia: information premium here.
imperfect market premia: X-costs and liquidity premium
(maybe even specic skills/buyers: market premium.)

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

Market imperfections can create higher/dierential expected rates of return,


like risk-aversion, too. The default premium does not.
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Opinions and Disagreements II


Do not confuse this (imperfect-market) discussion about dierences in expected
rates with (perfect-market) dierences in promised rates.
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For example, almost all entrepreneurs believe that they will succeedan
opinion. But they are also overcondent, and thus objectively often bad risks.
The fact that they have to pay higher quoted (promised) costs of capital thus
may often reect default risk, not just market imperfections.

Most of the yield spread of corporate bonds is due to higher default


probability.
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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%.

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What mechanisms can mitigate the disagreement market


imperfection?
Loan Covenants. Collateral. Credit Ratings. CDS.
Large corporations have credit ratings, too, from AAA (best) to F.
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AAA rms had 0% probability of default (one non-payment) over 5-10


years.

B rms had 20% probability of default.

C rm had a 50% probability of default.

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

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Transaction Costs

Try to think of roundtrip transaction costs.

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% in
various transaction costs.)
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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 accept
a lower price.
In terms of value-at-risk, i.e., as a fraction of the equity that is your own given
standard 80% nancing, this transaction cost eats up more than 25% of your
equity investment the moment you close.

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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 $1
million in a liquid stock like PepsiCo, including the price impact. The indirect
costs are often trivial, toomaybe $20.
You can think of this $1 million as just the equity portion. PepsiCo carries loans,
just like your house does.

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How do you take care of transaction costs in NPV?

They are easy to take care of in NPV. Just do everything post-transaction


costsboth expected cash ows, and your opportunity cost of capital (return
from investing elsewhere).

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What is a liquidity premium?


Liquidity Premium: An extra expected rate of return to induce you to hold
something that will be tough to resell if/when you are in a hurry.
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Strangely, the liquidity premium, which should be of second order


importance, seems to be very important. Witness for example the Russian
crisis or LTCM. The liquidity premium seems to have a strong interaction
with economy-wide nancial slack and aggregate borrowing.

Perhaps most money on WS comes from liquidity provision. (Same for


wholesalers and ordinary retail stores.)

If you run a fund, make some of your money through liquidity provisionbut
do not go overboard, or you will end up bankrupt.

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

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


negative?

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