ATTACHMENT 8-1
PHYSICAL RETURNS, ASSET PRICES, AND THE
TERM STRUCTURE OF FINANCIAL RETURNS

In a competitive financial market, the expected rate of return varies over time in a manner that equates the supply of, and demand for, savings. Savers directly invest in financial assets such as stocks and bonds that are issued by companies, they hold bonds issued by governments, and they also invest indirectly through financial institutions such as banks and mutual funds. Firms use the money raised from households and intermediaries to invest in physical assets—property, plant, and equipment—that are inputs into the production process. Over time, the income generated from such physical investments, net of expenses such as wages and maintenance, is used to pay interest and principal to bondholders and to pay dividends to stockholders or to repurchase their shares.

A simple example may help to illustrate the relationship between returns on financial assets, physical assets, and asset prices, and how those quantities are affected by the demand for and supply of savings. Consider a machine that produces $10 worth of output in excess of operating expenses every year forever. A firm finances the purchase of this machine by issuing a share of stock. The market value of the stock depends on the rate of return available to investors on similar investments. For example, if the expected rate of return is 5 percent over the next year and also for every year in the future on similar assets, then the price of the share would be $200. This is because the present value of a perpetual claim on $X, discounted at r percent per year, is $X/r. This price is consistent with the required return for investors: a 5 percent return on $200 is $10 per year.

If the cost of building another machine exceeded $200, no new machines would be produced because investors could make a higher return on alternative investments. Alternatively, if the production cost were less than $200, manufacturers would find unlimited demand for their products, since buyers could earn more than the 5 percent available on alternative investments. Thus, new machines would be put into production until the cost of building the units rose or the value of their output fell to the point where any additional machine built would earn 5 percent. Hence the forces of supply and demand for capital cause the expected return on any incremental unit of physical investment—the “marginal physical product of capital”—to equal the expected return on financial assets. The prices of existing financial and physical assets also adjust so that expected rates of return are equalized across investments. Those forces operate internationally; because investors seek the best investment opportunities at home and abroad, expected returns tend to be similar around the world. A more precise statement is that expected risk-adjusted returns are equalized; invest-



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