Financial Markets, Banking, and Monetary Policy

CHAPTER 4 The Pricing of Financial Assets

WHAT YOU WILL LEARN IN THIS CHAPTER

• The time value of money and the distinction between future value and present value.
• The present value formula linking the value of an asset today (its present value) to the future cash flows that the owner expects to receive from the asset and the discount rate (interest rate).
• How to use this relationship for determining the value of an asset when the cash flows and the discount rate are known; the amount of payments on an amortized, fixed-payment loan when the amount of the loan and interest rate are known; and the yield to maturity when the current price of an asset and its future cash flows are known.
• The valuation of a perpetual stream of cash flows—a consol—and ways that this relationship can be used for shorthand approximations of value.
• The relationship between the sensitivity of asset prices to interest changes and maturity.
• Risks that result when an investor’s holding period is longer or shorter than the maturity of the asset.
• The difference between yield and return.
• The concept of duration.
• The relationship between an asset’s duration and its maturity.
• The difference between the real interest rate and the nominal interest rate.
• An appendix to this chapter illustrates how to perform some of the calculations performed in this chapter on a financial calculator.

BACKGROUND

Have you ever wondered how the price (value) of an apartment building or an office building—each of which provides ...