REM 400

Lecture Two
Fundamental Concepts in Mortgage Valuation

Fundamental Concepts:
Outline of Lecture 2
Explanation of why this lecture is important and why
were spending time on it
Statement of the three fundamental concepts in finance
Exploring each concept:

Goods in finance are cash flows distinguished only by date

Interest rates in finance are just (relative) prices
Same financial good cannot have multiple prices

Summary: what you need to know from lecture two

Explaining Why Lectures 2-4 Are So Important

Why are we spending time on reviewing fundamental
concepts?

Finance students: we already know all of this stuff

REM students: I dont know this stuff but it sure looks different than
FIN 300

These are the most basic, fundamental concepts in finance:

Finance students: this stuff is the often-untold foundation of everything

youve ever done or will ever do (as a practitioner) in finance

REM students: the opportunity to ground your understanding of

finance and its applications from the ground up

How is this relevant to the application of finance to real

estate?

Three Fundamental Concepts

in Finance
Goods in finance: Income flows at different dates
are different goods
Prices in finance: an interest rate is the price of
a dollar of income today measured in dollars
received or paid at future date t
No arbitrage: a unit of income at any date has only
one price

Concept One:
Goods in finance
What is a good in ordinary or everyday life?
A good in ordinary life is an object or service that
is valued and consumed by you or others

Examples: a kilo of apples, a pint of beer, a newspaper, an

hour of labor by a doctor, dentist, professor, plumber
Goods are measured in physical units (kilo, pint, hour..)
Goods are distinguished from each other by many distinct
qualities: example of apple versus orange
Goods are traded in markets (apples and oranges at a
grocery, a home in a residential real estate market, etc.)

Goods in finance, ctd.

What is a good in finance?
A good in finance is a unit of income at a specific
date

Ask yourself: what is being traded in a financial market?

(stock and bond markets, mortgages in home finance
markets, an informal loan between friends, etc.
Goods in finance income or cash flows have only one
fundamental distinguishing feature: the date at which they
are paid or received
Goods in finance are also traded in markets (no differently,
in principle, than apples and oranges)

Goods in finance, ctd.

Buying or selling a good in ordinary life and buying or
selling a financial good are analogous
Examples in ordinary or everyday markets:

I buy a kilo of apples at Loblaws for $8.00 per pound

LCBO on Yonge sells me a liter of vodka for $24.00

You buy a house at Dundas and Parliament for $1.5 million

Examples in financial markets:

I buy a Canadian Treasury bill for $989,000 at 9am today

I loan CIBC $5,000.00 today at noon (example: CD)
Rob Ford buys 400 shares of Coca, Ltd. Ordinary stock right now

Goods in finance, ctd

Why are cash flows at different dates regarded as
distinct goods by financial practitioners?
Fundamentally, because there are (bond and equity)
markets in which there are individuals willing to
trade cash flows at one date for cash flows at a
different date (or dates.)

Final examples:

Treasury bill and Treasury bond markets (Canadian,

US, Europe, Japan)

Real estate:
secondary mortgage market - buying and selling existing
mortgages, either in whole or selected monthly coupon payments
from a mortgage;
structuring the financing of real estate development projects

Goods in finance, the bottom line

Why must you perceive cash flows at different
dates as different goods?
If you don't - that is, if you treat cash flows at one
date (say today) as no different than cash flows
at another date (say, tomorrow or a month from
tomorrow or ninety-one days from tomorrow,
etc) you will lose money, lose the possibility of
making a good deal of money. in these markets
or both

Concept Two:
Prices in Finance
Interest rates are just prices of income at different
dates
What is a price in an ordinary transaction?
What is a price in a financial transactions?

Interest rate: the (relative) price defined by trade of

income today for income at a specific future date
Discount rate: the (relative) price defined by trade of
income at a specific future date for income today

Prices in Finance, ctd.

Two kinds of prices: nominal and relative

nominal price: the number of dollars per unit of good

relative price: the number of units of good A per unit of
good B

Examples:

The nominal prices of a kilo of apples and a liter of vodka

are respectively $8.00 and $24.00
The relative price of a liter of vodka is three kilos of apples

Prices in Finance, ctd.

A nominal price of a good is the rate at which you exchange
money for one unit of the good
In precise or formal terms, its the ratio of dollars to one unit
of a good x (say x denotes the good apple):

this just means that the good being valued or priced is apples
and the units used to measure the value or price are dollars

the good being valued appears in the denominator

the good in which value is measured the numeraire appears in numerator (here this good is dollars)

Prices in Finance, ctd.

An example of how nominal prices in ordinary or everyday
purchases and sales are related to relative prices
say you go to Loblaws with only $48.00 to spend and want to buy
both apples and oranges. The price of apples is still $8.00/kilo and
the price of oranges is $4.00/kilo.

You initially choose put three kilos of apples ($24.00 in total) and four
kilos of oranges ($16.00 in total)

You then decide that you want four kilos of oranges, rather than three.
How many kilos of oranges do you have to put back on the shelf?

What is the price of a kilo of apples in terms of oranges?

Prices in Finance, ctd.

A relative price is an identical concept, except that the good used to
measure value dollars is replaced by another physical good
Example: if the nominal prices of vodka and apples are respectively
$24.00/liter and $8.00/kilo, the relative price of a liter of vodka,
measured in kilos of apples, is 3 (e.g., you could barter three kilos of
apples for a liter of vodka)
A relative price, in precise or formal terms, is a ratio of dollars to one
unit of a good x (say x denotes the good apple):

Prices in Finance, ctd.

The relative price of a good, in precise or formal terms, is the rate
at which you exchange one good for another good
In precise or formal terms, its the ratio of units of one good (say
good y or apples) to the good being valued or priced (say good
x or vodka):

this just means that the good being valued or priced is vodka and the
units used to measure the value or price are apples

the good being valued or priced appears in the denominator

the good in which value is measured the numeraire - appears in

numerator (here this good is apples)

Prices in Finance, ctd.

In finance, the goods are just cash flows at different dates
So what is the nominal price of one dollar today in terms of
dollars today? How about the nominal price of a dollar a
week from today in terms of dollars a week from today?
Since dollars at different dates are the goods exchanged in
finance, there are NO nominal prices in finance
There are only relative prices in finance

What is the price of a dollar today in terms of dollars paid or received a

week from today? (interest rate)

What is the price of a dollar a week from today in terms of dollars paid
or received today? (discount rate)

Prices in Finance, ctd.

An example of a relative price in finance (the beer loan)

Say I ask you, at the end of this class, for a loan of $5.00 to buy a pint of
beer and I tell you Ill pay you back one week from today (next class). You
agree but want a repayment in one week of $6.00. So you are exchanging
five units of income today for six units of income in one week

What is the (relative price of a dollar today?

What is the (relative) price of a dollar in one week?

Prices in Finance, ctd.

What is the (relative price of a dollar today?

Pricing a unit of income today in terms of income in one week is simply

using units of income next week (good y) to measure the value or price of
a dollar today (good x)

If 6 units of income next week trade for 1 unit of income today, the relative
price of income today, measured in units of income next week, is 6/5 or 1.20

So your investment in this loan increases by 20% over one week

Prices in Finance, ctd.

In finance, this relative price is called a (market) interest rate

Practitioners commonly state this interest rate formally known as a bond

equivalent interest rate - in one of two equivalent ways:

The gross bond-equivalent interest rate:

The net bond-equivalent interest rate:

(Explanation of notation)

Prices in Finance, ctd.

You might instead ask what is the (relative) price of a dollar in one week?

Pricing a unit of income in one week in terms of income today is simply

using units of income today (good x) to measure the value or price of a
dollar in one week (good y)

If 5 units of income today trade for 6 units of income in one week, the
relative price of income in one week, measured in units of income today, is
5/6:

In finance, this is known as a (market) discount rate

Prices in Finance, ctd.

Second example: a simple 90-day (three month) Canadian Treasury bill

You want to buy a three month Canadian T-bill today. This is a bond, issued
by the Canadian government, which pays you $100.00 in three months
(face value or F) in exchange for a number of dollars you bid for it today
(bond price or B_0)

Say you bid $99.50 today for this bond and you win the Bank of Canadas
auction for it. You have agreed, by doing this, to exchange 99.5 units of
income today for 100 units of income in 3 months. You have, consequently,
determined the three month (riskless) interest rate and the three month
discount rate in Canada

What is the price of a dollar today measured in terms of dollars in 3

months?

What is the price of a dollar in three months measured in terms of dollars

today?

Prices in Finance, ctd.

The price of a dollar today measured in terms of dollars in 3 months is

known as the (three month) bond-equivalent interest rate. Its gross and net
values are:

The price of a dollar in three months measured in terms of dollars today is

known as the (three month) discount rate. Its value is:

Practitioners commonly state this interest rate formally known as a bond

equivalent interest rate - in one of two equivalent ways:

Prices in Finance, ctd.

Second example: a simple 90-day (three month) Canadian Treasury bill

You want to buy a three month Canadian T-bill today. This is a bond, issued
by the Canadian government, which pays you $100.00 in three months
(face value or F) in exchange for a number of dollars you bid for it today
(bond price or B_0)

Say you bid $99.50 today for this bond and you win the Bank of Canadas
auction for it. You have agreed, by doing this, to exchange 99.5 units of
income today for 100 units of income in 3 months. You have, consequently,
determined the three month (riskless) interest rate and the three month
discount rate in Canada

What is the pri

Prices in Finance, ctd.

Both the one-week beer bond and the three-month Canadian T-bill have a
specific form:

The bond seller (also known as the borrower) promises to pay the lender some amount of
units of income at the maturity date - this is known as the face value of the bond and in
class (for now) denoted by F

The bond buyer (also known as the lender) offers, in exchange for F, some amount of units of
income today this is known as the bond price or loan principal and in class will be
denoted by B_o

This form of bond (loan) is known in finance as a zero-coupon bond.

The crucial aspect of any zero-coupon bond is that it involves a trade of two
and only two goods: income at the maturity date (F) and income today
(B_o). Hence it determines a relative price (either the interest rate over
the term to maturity or the discount rate over that term)

Prices in Finance, end

Since only zero-coupon bonds involve the exchange of two goods (units of
income or cash flows at two and only two different dates), they have two
absolutely essential qualities:

Zero coupon bonds are the ONLY bonds that exhibit true interest rates

Every other financial asset (under current conditions) is simply a portfolio

of zero-coupon bonds with different maturity dates.

So, as a consequence, every other type of bond (for example, a mortgage) is

simply a bundle or portfolio of zero-coupon bonds. In real estate finance,
the face values of these component zero-coupon bonds are the monthly
coupon payments of a mortgage.

This means (you will be shown) that you can deduce the current market
price (gross present value) of a mortgage or any other type of bond by
determining the current prices of each component zero-coupon bond and
adding them all together!