Capital Market PPT by Komilla Chadha

Capital Markets

By Komilla ChadhaApril 2012

Wednesday, 11 April 12

Outline

• Efficient Market Hypothesis

• What is financial capital and real capital?

• Demand for (real) capital

• Relationship between rental rate and interest rate followed by interest rate determination

• What is the criteria for buying a capital good?

• Bonds


Efficient Market hypothesis

The hypothesis states that all financial assets are informationally efficient i.e. they convey a wide array of information such as market mood.


Financial and Real Capital

•Financial capital is money or any other paper asset that functions as money whereas real capital doesn't function as money, it is a productive asset and is sometimes called physical capital.


Demand for real capital

•If a firm can employ capital at a constant rental rate then it should do so till the point where the marginal revenue product is exactly equal to the rental rate.

•This is because if marginal revenue < rental rate is less it is uneconomical and not financially viable and if marginal revenue > rental rate, there is still scope to increase productivity.


Interest rate and capital: Interest rate determination

•Interest rate is determined by the supply and demand for loanable funds and where they intersect.

•This affects capital rental rate as people usually demand a loan to purchase or rent capital as they are expensive.

•Demand for capital is also affected by rates of technology and physical depreciation and this is clear in the formula, rental rate = interest rate + maintenance expenses + depreciation.


Interest rate and capital : Formula

• Physical depreciation of capital is only one way capital loses value, another is technological obsolescence which is a process where technology improves and substitutes become more attractive. This is important when understanding the formula between interest rate and rental rate.

• FORMULA: Rental rate of capital = Interest rate + Maintenance expenses + Depreciation

• Essentially rental rate is the all the different costs of capital added together.

• This ties with the criteria for buying capital.


Criteria for buying capital

• You want goods which are not only productive today but are going to be productive in the future too.

• Thus, the firm should buy a good if only the present value is great than or same as the price of capital.

• However, present value is is inversely related to market rate of interest, thus the lower the market rate, the greater the present value and more the firms will want to own capital.


Market for bonds

•Bonds are basically IOUS; short-term bonds are like 90 days long and long term 30+ years. They are a type of loan.

•A perpetual bond is a bond that pays a fixed payment each year in perpetuity.

•A risk premium is a payment differential necessary to compensate the supplier of a good or service for having to bear risk. This can be applied to stocks and bonds or any other financial asset.


Thank you for reading!

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Capital Market PPT by Komilla Chadha