Background Financial The-ory
• Philosophers have been against interest for thousands of years.
• That is because they didn't understand what causes interest.
• Irving Fisher concluded that the real rate of interest is determined by market participants' preferences and endowments
Present Value and interest rates
• Nominal Interest Rate – Inflation• US Government bonds have an “Inflation
protected” rate allowing us to calculate the real interest rate roughly.
• http://www.bloomberg.com/markets/rates-bonds/government-bonds/us
Real Interest Rate
• We can not be sure about the future.• Generally some assets such as US govern-
ment bonds are classified as risk free and other assets have ratings against this asset.
• This uncertainty is classified.• Rating agencies• Risk and Return
Uncertainty
• There is a diversification benefit which re-duces risk.
• This is possible to quantify in a mathematical equation but has been understood for thou-sands of years.
• Don’t put all your eggs into one basket.
Diversification
• The market functioning by itself without inter-ference from the outside, in other words a situation of laissez-faire, leads to allocations that are Pareto efficient. At least if there are no externalities and there's no monopoly. So government shouldn’t interfere.
Efficient markets
• Price is determined by marginal utility, water and diamonds
• Some people have more money and prefer certain things.
• Supply and demand
Marginal Utility
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