15.

415x Foundations of Modern Finance

Leonid Kogan and Jiang Wang
MIT Sloan School of Management

Lecture 2: Market Prices and Present Value

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 15.415x Lecture 2: Market prices and PV

Key Concepts
■ State-space model for time and risk
■ Arbitrage pricing
■ Present value and future value
■ Nominal vs. real cash flows and returns

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 15.415x Lecture 2: Market prices and PV

Key Concepts
■ State-space model for time and risk
■ Arbitrage pricing
■ Present value and future value
■ Nominal vs. real cash flows and returns

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 15.415x Lecture 2: Market prices and PV

State space model for time and risk

■ Consider a simple model to capture the two
𝑠𝑠 = 1, 𝑝𝑝1
elements in finance: time and risk.
𝑠𝑠 = 2, 𝑝𝑝2
■ There are two dates: 𝑡𝑡 = 0, 1.
■ There are 𝑁𝑁 possible economic states at 𝑡𝑡 = 0 ⦙
𝑡𝑡 = 1: 𝑠𝑠 = 1, … , 𝑁𝑁, with probabilities 𝑝𝑝1 , 𝑝𝑝2 , 𝑠𝑠 = 𝑁𝑁 − 1, 𝑝𝑝𝑁𝑁−1
..., 𝑝𝑝𝑁𝑁 .
𝑠𝑠 = 𝑁𝑁, 𝑝𝑝𝑁𝑁
■ States and probabilities are known to all
decision makers.
0 1 time

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 15.415x Lecture 2: Market prices and PV

State-space model
■ Assume frictionless financial market for 𝑋𝑋1𝑖𝑖 , 𝑝𝑝1
simplicity.
𝑋𝑋2𝑖𝑖 , 𝑝𝑝2
■ Assets can be traded at time 𝑡𝑡 = 0 with
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑖𝑖 ⦙
payoffs at time 𝑡𝑡 = 1.
𝑖𝑖
■ The price of an asset is 𝑃𝑃 at 𝑡𝑡 = 0 with 𝑋𝑋𝑁𝑁−1 , 𝑝𝑝𝑁𝑁−1
payoff 𝑋𝑋 = (𝑋𝑋1 , … , 𝑋𝑋𝑁𝑁 ) at 𝑡𝑡 = 1. 𝑋𝑋𝑁𝑁𝑖𝑖 , 𝑝𝑝𝑁𝑁
■ 𝑋𝑋 is a random variable.

■ A random payoff is given by the value of

its payoff in each state and the
corresponding probability:
[(𝑋𝑋1 , … , 𝑋𝑋𝑁𝑁 ); (𝑝𝑝1 , … , 𝑝𝑝𝑁𝑁 )]

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 15.415x Lecture 2: Market prices and PV

State prices
■ Consider primitive state-contingent claims 0
(Arrow-Debreu securities) that pay $1 in a
single state and nothing otherwise. ⦙

■ Denote the price of the A-D claim on state 𝑗𝑗 𝜙𝜙𝑗𝑗 1, 𝑠𝑠 = 𝑗𝑗

by 𝜙𝜙𝑗𝑗 , the state price for state 𝑗𝑗. ⦙
■ No arbitrage requires that all state prices
0
must be positive: 𝜙𝜙𝑗𝑗 > 0 for all 𝑗𝑗.
■ The market is called complete if one can
effectively trade A-D securities on each
state.
■ Complete market is a useful abstraction.

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 15.415x Lecture 2: Market prices and PV

Key Concepts
■ State-space model for time and risk
■ Arbitrage pricing
■ Present value and future value
■ Nominal vs. real cash flows and returns

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 15.415x Lecture 2: Market prices and PV

Arbitrage pricing
■ With the prices of A-D securities, we can price other assets/securities.
■ Consider a two-state economy (𝑁𝑁 = 2) with three assets:
1 0
■ A-D securities, paying and ,
0 1
3
■ Asset 𝑋𝑋 paying .
5
■ How is the price of the third asset related to the prices of the first two?
■ Think of the third asset as a portfolio of the first two assets:
3 1 0
=3× +5×
5 0 1
■ Claim: price of asset 𝑋𝑋 is:
𝑃𝑃 = 3 × 𝜙𝜙1 + 5 × 𝜙𝜙2

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 15.415x Lecture 2: Market prices and PV

Arbitrage pricing
■ The third asset can be replicated as a portfolio of A-D securities: 3 units of
A-D security 1, and 5 units of A-D security 2.
■ By no arbitrage, its price must equal the price of the replication portfolio:
■ No arbitrage requires:
𝑃𝑃 = 3 𝜙𝜙1 + 5 𝜙𝜙2
■ If not, agents can generate arbitrage profits. How?
■ Law of One Price: Two assets with the same payoff must have the same
market price.
■ If we have the prices of A-D securities, we can price all other securities: just
replicate them as portfolios of A-D securities.
■ What if we have prices of a bunch of “composite” securities?

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 15.415x Lecture 2: Market prices and PV

Arbitrage pricing
Example. (Concept check)
Suppose there are two economic states next year.
■ Safe government bond pays an interest rate of 5%;
■ A stock with price $100 yields the following payoff next year: (90,120).

What should be a proper set of state prices?

■ From the price and payoff of government bond:
100 = 105𝜙𝜙1 + 105𝜙𝜙2
■ From the price and payoff of the stock:
100 = 90𝜙𝜙1 + 120𝜙𝜙2
■ Solving for 𝜙𝜙1 and 𝜙𝜙2 yields:
10 10
𝜙𝜙1 , 𝜙𝜙2 = ,
21 21

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 15.415x Lecture 2: Market prices and PV

Arbitrage pricing
Example. (Concept check)
■ Suppose there are two states next year. The payoff of a share of stock and
the probabilities of the states are:
[($90, $110); (0.4, 0.6)]
■ The state prices for the two states are:
𝜙𝜙1 , 𝜙𝜙2 = (0.5, 0.4)
Questions:
1. What is the stock price today?
2. What is the expected rate of return of the stock?

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 15.415x Lecture 2: Market prices and PV

Arbitrage pricing
Example (cont’d).
■ Stock price today:
𝑃𝑃 = 𝜙𝜙1 𝑋𝑋1 + 𝜙𝜙2 𝑋𝑋2 = 0.5 90 + 0.4 110 = 89
■ Expected rate of return on the stock, 𝑟𝑟:̅

𝐸𝐸 𝑋𝑋 − 𝑃𝑃 𝑝𝑝1 𝑋𝑋1 + 𝑝𝑝2 𝑋𝑋2 0.4 90 + 0.6 110 102 13

𝑟𝑟̅ = = −1= −1= −1=
𝑃𝑃 𝑃𝑃 89 89 89
■ Given the expected return on the stock by the market, we have:
𝐸𝐸 𝑋𝑋 102
𝑃𝑃 1 + 𝑟𝑟̅ = 𝐸𝐸 𝑋𝑋 ⇒ 𝑃𝑃 = = = 89
1 + 𝑟𝑟̅ 1 + 13/89

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 15.415x Lecture 2: Market prices and PV

Arbitrage pricing
■ In general, in a complete market we can value any cash flow by the no-
arbitrage principle (P1).
■ Suppose the firm is considering a project yielding time-1 cash flow:
𝑋𝑋 = 𝑋𝑋1 , 𝑋𝑋2 , … , 𝑋𝑋𝑁𝑁
■ Using prices of A-D securities, we can attach value to this cash flow as
𝑃𝑃 = 𝜙𝜙1 𝑋𝑋1 + ⋯ + 𝜙𝜙𝑁𝑁 𝑋𝑋𝑁𝑁 = 𝑃𝑃𝑃𝑃
■ This valuation formula encapsulates the arbitrage/relative pricing principle.
■ PV is the present value of the project/asset/CF.
■ PV is also given by the expected payoff and the expected rate of return.
■ Key idea: Find traded assets with similar cash flows (in timing and risk),
use their price/expected return to value the given asset.

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 15.415x Lecture 2: Market prices and PV

Key Concepts
■ State-space model for time and risk
■ Arbitrage pricing
■ Present value and future value
■ Nominal vs. real cash flows and returns

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 15.415x Lecture 2: Market prices and PV

Present value (PV)

Example 1. How much is a sure cash flow of $1,000 in one year worth now?
Market: Safe assets traded in the market offer annual return of 2%.
A potential buyer of the sure CF also expects 2% return. Let the price she is
willing to pay be 𝑃𝑃. Then:
𝑃𝑃 1 + 0.02 = $1,000
Thus,
$1,000
𝑃𝑃 = = $980
1.02
which is the CF's present value.

Observation: Present value properly adjusts for time.

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 15.415x Lecture 2: Market prices and PV

Present value (PV)

Example 2. How much is a risky cash flow in one year with a forecasted value
of $1,000 worth now?
Market: Traded assets of similar risk offer expected annual return of 20%.

A potential buyer of the risky CF also expects 20% return. Let the price be P.
Then:
𝑃𝑃 1 + 0.20 = $1,000
Thus, the present value of the risky CF is:
$1,000
𝑃𝑃 = = $833
1.20
Observation: Present value properly adjusts for risk.

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 15.415x Lecture 2: Market prices and PV

Present value and discount rate

The current market value of a CF (its PV) is determined by
■ its expected payoff;
■ discounted at an appropriate discount rate,
where the discount rate is given by the expected rate of return on traded
assets with similar cash flows (in timing and risk):

𝐸𝐸[𝐶𝐶𝐶𝐶]
𝑃𝑃𝑃𝑃 =
1 + 𝑟𝑟̅
Thus,
■ the value of an asset (cash flow) is determined by the financial market
(via the discount rate/expected rate of return/required rate of return);
■ the discount rate properly adjusts for time and risk;
■ the discount rate is also called the opportunity cost of capital (COC) –
return offered by similar assets traded in the market.

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 15.415x Lecture 2: Market prices and PV

Present value (PV)

𝐶𝐶𝐶𝐶𝑇𝑇
𝑃𝑃𝑃𝑃 𝐶𝐶𝐶𝐶𝑇𝑇 =
(1 + 𝑟𝑟)𝑇𝑇

From now on, for simplicity, we will use 𝑟𝑟 (instead of 𝑟𝑟)̅ to denote discount
rates (unless noted otherwise).

Example. (A) $10M (million) in 5 years or (B) $15M in 15 years. Which is

better if 𝑟𝑟 = 5%?
10 15
𝑃𝑃𝑃𝑃𝐴𝐴 = = 7.84; 𝑃𝑃𝑃𝑃𝐵𝐵 = = 7.22
1.055 1.0515

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 15.415x Lecture 2: Market prices and PV

Present value (PV)

PV of $1 Received In Year t
$1.0
r = 0.04 r = 0.08 r = 0.12
$0.8

$0.6

$0.4

$0.2

$0.0
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30
Year when $1 is received

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 15.415x Lecture 2: Market prices and PV

Present vs future value

■ We can bring $ back from the future, discounting at the proper discount
rate.
■ We can also send $ into the future, growing at the proper return rate.

PV vs FV
1.8

1.3

0.8
0 1 2 3 4 5 6 7 8 9 10

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 15.415x Lecture 2: Market prices and PV

Future value (FV)

■ How much will $1 today be worth in one year if the interest rate is 4%?
■ $1 investable at a rate of return 𝑟𝑟 = 4%;
■ FV in 1 year:
𝐹𝐹𝐹𝐹 = 1 + 𝑟𝑟 = $1.04
■ FV in 𝑇𝑇 years:
𝐹𝐹𝐹𝐹 = $1 × 1 + 𝑟𝑟 × ⋯ × (1 + 𝑟𝑟)
= (1 + 𝑟𝑟)𝑇𝑇
Example. Bank pays an annual interest of 4% on 2-year CDs and you deposit
$10,000. What is your balance two years later?
𝐹𝐹𝐹𝐹 = $10,000 × (1 + 0.04)2 = $10,816

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 15.415x Lecture 2: Market prices and PV

Present value (PV) and CF

Comparing cash flows:

Example. Drug company has developed a new flu vaccine and needs to
choose between two strategies:
■ Strategy A: To bring to market in 1 year, invest $1B (billion) now and
returns $500M (million), $400M and $300M in years 1, 2 and 3,
respectively.
■ Strategy B: To bring to market in 2 years, invest $200M in years 0 and 1,
and returns $300M in years 2 and 3.
How to value/compare the two strategies (i.e., their CFs)?

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 15.415x Lecture 2: Market prices and PV

Present value (PV) and CF

𝐶𝐶𝐶𝐶1 𝐶𝐶𝐶𝐶2 𝐶𝐶𝐶𝐶𝑇𝑇
𝑃𝑃𝑃𝑃 𝐶𝐶𝐶𝐶1 , 𝐶𝐶𝐶𝐶2 , … , 𝐶𝐶𝐶𝐶𝑇𝑇 = + + ⋯+
(1 + 𝑟𝑟) (1 + 𝑟𝑟)2 (1 + 𝑟𝑟)𝑇𝑇
Assume that 𝑟𝑟 = 5%.
■ Strategy A:
Time 0 1 2 3
Cash Flow -1,000 500.0 400.0 300.0
Present Value -1,000 476.2 362.8 259.2
Total PV 98.2

■ Strategy B:
Time 0 1 2 3
Cash Flow -200 -200.0 300.0 300.0
Present Value -200 -190.5 272.1 259.2
Total PV 140.8

Firm should choose strategy B, and its value would increase by $140.8M (vs.
$98.2M for strategy A).

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 15.415x Lecture 2: Market prices and PV

Key Concepts
■ State-space model for time and risk
■ Arbitrage pricing
■ Present value and future value
■ Nominal vs. real cash flows and returns

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 15.415x Lecture 2: Market prices and PV

Nominal vs real CFs

Example. Inflation is 4% per year. You expect to receive $1.04 in one year,
what is this CF really worth next year?

■ The inflation adjusted or real value of $1.04 in a year is:

Nominal CF $1.04
Real CF = = = $1.00
1 + inflation 1 + 0.04
■ Nominal cash flows ⇒ expressed in actual-dollar cash flows.
■ Real cash flows ⇒ expressed in constant purchasing power.

■ At an annual inflation rate of i, we have:

(Nominal 𝐶𝐶𝐶𝐶)𝑡𝑡
(Real 𝐶𝐶𝐶𝐶)𝑡𝑡 =
(1 + 𝑖𝑖)𝑡𝑡

■ http://www.tradingeconomics.com/country-list/inflation-rate

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 15.415x Lecture 2: Market prices and PV

Nominal vs real rates

■ Nominal rates of return ⇒ prevailing market rates.
■ Real rates of return ⇒ inflation adjusted rates.

Example.
■ $1.00 invested at a 6% interest rate grows to $1.06 next year.
■ If inflation is 4% per year, then its real value is
$1.06
= 1.019
1.04
■ The real rate of return is 1.9%.

1 + 𝑟𝑟nominal
𝑟𝑟real = − 1 ≈ 𝑟𝑟nominal − 𝑖𝑖
1 + 𝑖𝑖

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 15.415x Lecture 2: Market prices and PV

Nominal vs real CFs and rates

Example. Sales is $1M this year and is expected to have a real growth of 2%
next year. Inflation is expected to be 4%. The appropriate nominal discount
rate is 5%. What is the present value of next year’s sales revenue?
■ Next year’s nominal sales forecast: ($1M)(1.02)(1.04) = $1.0608M.
1.0608
𝑃𝑃𝑃𝑃 = = 1.0103
1.05
■ Next year’s real sales forecast: ($1M)(1.02) = $1.02M.
1 + 𝑟𝑟nominal 1.05
𝑟𝑟real = −1= − 1 = 0.9615%
1 + 𝑖𝑖 1.04
1.02
PV = = 1.0103
1.009615
■ For valuation calculations, treat inflation consistently.
■ Discount nominal cash flows using nominal discount rates.
■ Discount real cash flows using real discount rates.

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 15.415x Lecture 2: Market prices and PV

Summary
■ State-space model for time and risk
■ Arbitrage/relative pricing
■ Present value and future value
■ Nominal and real cash flows and returns

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