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Market Hybrids Markets are not always resolved in the current time period which is to say that not all products are sold or stored and not all available income is exhausted in consumption but some can be saved. This evaluation depends of specific market endowments and the interaction between the environment and the individual and is also dependent on the structure of the local economy. If a market extends from one period to another it involves both benefits and costs associated with the amount of funding or product that is carried over. It can also be used to evaluate whether something is worthwhile doing or not and whether a value from the future can be drawn into the present. Specific market forms have been created to handle issues such as: futures markets and project evaluation and justification
The Fischer Capital Separation Theorem • The theorem argues that consumption can be postponed in order to move to consumption points not otherwise accessible if the appropriate current period sacrifice is made. (Short term pain for long term gain!) Initial Trade Off Between Consumption in Periods 1 and 2 Note: C1’:C2’ and C1”:C2” are both feasible solutions depending on how valuable consumption ion period 1 is compared to how valuable it is in period 2 (The discount rate ) However, C1^:C2^ and C1*:C2* are not feasible for either discount rate but depend on how people are rewarded for delaying consumption this is the inerest rate. Consumption Period 1 New Trade Off Between Consumption in Periods 1 and 2 C1^ C1” C1’ C1* Consumption Period 2 C2* C2^ C2’ C2”
Discount Rates and Interest Rates • The Discount Rate is the rate at which some good or financial vehicle decays through time. It can be related to vegetables that actually rot or to the value of storing cash in your mattress when you know that whatever you save will be worth less when you spend it because of inflation. In the diagram there are a number of points that you might find feasible such as C1’:C2’ or C1”:C2” • Interest rates area reward for giving up consumption voluntarily and getting paid by a financial institution for your frugality. This allows you to get beyond the feasibility curve if and only if current consumption is given up. The amount will vary depending on your circumstance and will make C1^:C2^ or C1*:C2* feasible or attainable. • In the case of saving people will give up either C1’-C1* or C1”-C1* in order to consume C2* in the second period. • In the case of hoarding people will give up C2’-C2^ or C2”-C2^ in order to consume C1^ in the current period. • The policy objective here is to set up systems that minimize any discrepancies between the discount rates and using a centralized banking system to set a standardized interest rate to be able to influence inventories and savings within the community and thereby achieve macroeconomic objectives.
Methods of Reconciliation of Discount Rates • There are several methods that are used to stabilize the discount rates. These include government leadership making speeches that appeal to nationalism or public pride in a specific method of behavior. They can include government power to enforce a specific discount rate through taxation policies. They can move government procurement into an area to absorb surpluses or create temporary shortages although these are difficult to control. They can change cultural expectations through manipulative information releases in order to achieve other policy ends. • The private sector can also make a difference and usually does this through establishing self-policing mechanisms that define marketing processes (futures markets) or establish protocols which are applied to projects in order to minimize or control variability in outcomes. (project evaluation).
Futures Markets • Futures markets exist in order to provide for price stability for both producers and consumers. A futures market exists for a product that is produced by many independent producers, that is homogeneous throughout, and that is produced In a fairly well understood production cycle. Products included in this are fixed weather dependent production cycles such as wheat , flax , oats , barley, coffee, and sugar and also variable production cycles of a fixed length such as pork bellies, crude oiland gold. The fixed production cycle is determined by biology , geology, or technology . • In a futures market an exchange is created and producers and buyers agree to a set of rules that govern how the products will be sold. These rules always include the size and timing of a contract (how much the unit of sale or purchase will be in physical terms and when it will be delivered), the limits of pricing change in a given day (how much the price will go up or down before trading is halted) and the margin (how much will be required to be paid or delivered if the limit is reached for a specific period of time.) • Active participants in the market are those who produce or consume the product and those who are willing to gamble or speculate on what the price will be at a specific point in time. No contract is let unless there is a buyer matched to a sellers on exactly the same terms. Producers will hedge their production by buying a contract in the market at a specific set price. This is the amount that they will actually receive when they actually deliver the product. Consumers, usually large corporations will sell a contract at a specific price which they will actually pay when they are actually delivered a product. If the street price is lower than the contract price then the producer will gain and the consumer will lose. If the street price is higher than the contract then the producer will lose and the consumer will gain. • Impacts on this system include weather that destroys crops, environmental disasters that destroy infrastructure, world affairs that lead to economic collapse and this is what encourages speculators to enter and stay in the market.
Capacity and Futures Market Issues • In the event of a crop failure supply will drop and producer hedges will lose while consumer hedges will gain. In the event of a sudden environmental disaster consumer hedges will lose and producer hedges will gain. The opposites may also occur. Quantity Product Availability Expected Shortage Time Storage Capacity Un-expected Product Availability Un-expected Storage Capacity Expected
, Project Evaluation and Justification • Projects are defined a s a complete turn-key option in which the costs of doing something include all of the costs directly associated with a project and all of the costs indirectly associated with the project including taxation issues and any and all costs that are involved in cleaning up the project such that it never existed. • The direct costs include all training and all capital investment that are considered part of the project extended throughout the expected life of the project using the technique of the time value of money. This approach argues that any investment made today will still have value in the future at least as valuable as if the agent had properly chose the correct combination of C1:C2 that was justified by his or her endowment of resource. In other words the agent used the correct discount rate to figure out what the investment would be worth in the future. • Note the discount rates depend on endowments but if there is a market based indication of what an acceptable return to risk is , called the risk premium then all projects can be compared. The terminology that is used id the Capital Assets Pricing Model which states that for every project there exists a Beta value such that : • This states that the influence of external factors through covariance of the project (Ri) and the market (Rm) divided by the variance in the market (Rm) is a constant and if greater than one indicates that the project should be proceeded with, if equal to one indicates that the project is a toss up and if less than one indicates that the project should not proceed.
CAPM and Project Evaluation Beta > 1 Beta = 1 Project Re-evaluation Point is where Beta is >1 and tangent to net revenues. Project Zenith Point is where marginal net revenues begin to fall. Value Net Revenues Beta < 1 Time Project Re-evaluation Point Project Zenith Point
Analytics Of Capital Markets • The CAPM model shows that there is a project re-evaluation point at which the increase in revenues begins to slow down. This is appoint at which the economic agent should evaluate weather the project is indeed valuable to proceed with beyond its initial stages. Ina business plan this is when an agent should consolidate the plans and drawings before any physical commitments are made. It establishes the Ri in the CAPM model and sets the rate of risk premium. • The project zenith is where the net revenues start to decline at the margin and is a point at which to start considering winding down the project or augmenting it for another application or selling the project to a different concern. It establishes the relationship between the covariance of the project and its variance. • In this fashion the discount rates are made as compliant with each other as possible and allows for the evaluation of future benefits and immediate reactions to the marketplace to compensate for the fact that uncertainty pervades these markets and those who take risk should be adequately compensated.
