So far we talked a bit abstractly about markets. Yes, we used some specific products for examples, such as white wine, rental apartments, and perhaps airline pricing, but we have not yet developed a particular market model specifically for a particular product. In this post, I want to do this for a particularly important market: the market for money. This post gives a first account of the basic insights and ingredients that underlie our understanding of credit markets and financial markets. You will see, I hope, that what we have learned so far, especially about supply and demand, while not enough to understand these markets fully, was also not in vain. It will come in handy.
Suppose you have an idea for a new product or a new project that you believe many people would find useful, and that, because of that, you would make some money with it. For instance, suppose you happen to own a cave in the mountains and you think it would be a great place for a server farm: a bunch of large scale computers. One of the biggest costs in running such a farm, supposedly, is the cost of cooling and you think that, as your cave is always pretty cool, it would be a good place for such a server farm. You could save on cooling costs and could thus be more competitive (or profitable) than other server farms. Suppose that you believe that this idea of yours most likely will make you a decent amount of money. In other words, you believe that there will be substantial demand for the services of your server farm so that you could make some money with this. The catch, however, is this: installing your server farm requires a certain amount of money to begin with. You need to buy the servers and make sure you have access to electricity and the internet, et cetera. You probably have to do a bit of construction work to install the servers as well. The catch, now really, is this: You do not have that sort of money. So, what do you do?
Well, you try and get a loan from someone who has money and doesn’t quite know what to do with it (doesn’t perhaps have such a great idea as yours). So, will someone (like this) lend you this money? The answer, of course, is that it all depends. But we can now figure out what it depends on.
So the first thing, I guess, that your bank or other potential financier would demand from you is a business plan. Then they will assess for themselves how they see the potential of your project. This is obviously pretty difficult. In other classes, I am hoping, you can learn how to assess the potential future demand for your product or services and how to translate this into a probability assessment about potential future revenue that you might make with your product or services. Let us here simply assume that this was done, to the best of everyone’s ability. And that the general assessment among people who might give you money about your project is this:
You will need to borrow about € 100.000 for the initial investment. You will need to put in one year of hard work. Then people believe that there is 20% chance that things will not go so well (that the future demand for your servers is low). In this case they estimate that you would be able to recoup only about € 50.000 (so you are making a loss of € 50.000 – even without counting the time you put into it). But, they also think that there is an 80% chance that things will go very well (that the future demand for your servers is high). They estimate that in that case your server farm would make about € 300.000. That is you make a net profit of €200.000 (still not counting your time investment).
So will you get a loan for € 100.000? Should you get this loan? Let’s put all this information into a table.
Let us first start with the question, assuming this assessment is correct and the best we can do, whether you should get a loan. Note that the expected income, according to this assessment, is Does this mean you should get this loan? Well, my answer would be: “probably yes!” To give a firm answer, we need to know a bit more about the risk inherent in this project.
Note first that it is clear that there is some risk. It is also clear that if the project turns out to be bad, then ex post (I mean after it is all done and turns out to be bad) we regret that you pursued your project. Why? Well, the project in that case cost more than it made and that’s probably because people didn’t really use its services, which in turn means that it probably did not provide much benefit to anyone. But this is with the benefit of hindsight. At this moment when we have to decide we do not know whether the project will turn out to be bad or good. If it does turn out to be good, it is likely not only good for you but also for the people who use the services that they buy from you. If you recall how things enter GDP, your project would in this good case, enter with € 200.000 and possibly would have provided more benefit than this (that we cannot quite measure).
Now why do I say it is probably a good idea that you get this loan? Suppose for a moment that the risk inherent in your project is largely uncorrelated with any other risk in this world. This is probably not completely justified. It means that whether your project turns out to be good or bad has little to with the success of any other project other people are pursuing. But then, imagine lots of such projects. Then on average they would make a net profit of € 150.000, which means that on average the project creates net benefits that measured in monetary terms exceed at least € 150.000. Now, it is possible that while the project creates some benefits to its paying customers it might also create some costs (of some kind) for other customers. I will assume that this is not the case here, but we should come back to this, and we will, when we talk about externalities. And the total risk is then very small. I will come back to this in one moment. So you probably should get the loan (under these assumptions).
But will you get a loan? And if so, under what conditions? Let us think about the range of feasible loan conditions. We can here think about a loan as a repayment amount in case the project turns out to be good. If the project turns out to be bad, let us here assume, for simplicity, that then there is only the € 50.000 left to be repaid. This means that the risk inherent in this project is then fully borne by the investor, the person who lent you the money. Let us call this repayment amount . What is then the range of feasible values for ? Consider this table:
As a function of this repayment amount the expected earnings are
The best you can hope for is a value in which case the investor expects to make on average The investor would certainly not accept anything lower than this, assuming she or he wants to make money with her investment. Your interest rate would then be 12.5\%. You borrow €100.000 and, in case things go well, pay back €112.500, and in case things go badly, the loss is the investor’s.
The worst for you, that you might just accept, but probably wouldn’t, would be a value You certainly wouldn’t accept a higher value. So let us assume that the possible range of interest rates that the two of you (you and the investor) might agree on is between 12.5% and 200%. You might now say, that you don’t really expect that the investor would accept an interest rate of 12.5% (seeing that this would give the investor zero expected return from her investment and there is risk for her or him as well) and also that you don’t really expect that you would accept such a high rate of 200% (and you are probably right). I will come back to both of these questions in the next two or three blog posts. These are central questions, indeed. But for the moment let us assume that they both would. So what interest will the two parties then agree on?
To answer this, at least to a satisfactory first approximation, we can turn to our supply and demand idea. Money is really a pretty homogenous good. With that I mean that any € 10 you own I would also value at € 10 and vice versa. Or in other words, people typically don’t care whether they get €10 from one person or another. People feel, on the whole, that pecunia non olet. This isn’t always true. A university, for instance, might decide not to accept money from someone considered to have made their money illegally or to have otherwise committed crimes. But I guess it is fair to say that whether you get your loan from bank A or bank B is really not that important as long as the conditions are the same. This means, that you are likely to go to many banks and to try to get the best deal. Investors (such as banks), on the other hand, probably consider various investment opportunities and pursue those that they find most lucrative. So we can imagine a demand function for loans (of various riskiness) and a supply function of money for such loans. The interest rate for your loan will then probably be more or less the market interest rate for loans with such riskiness that more or less equates the demand and supply of money. If there is a lot of money around and only few ideas, as it seems to be a little bit at the moment, then you would expect to get a pretty good rate close to 12.5% (for your loan). If unused money is rare and there is an abundance of great ideas, we would not expect such a low rate (for your loan).