Transcript Chapter 15: Financial Markets and Expectations

CHAPTER
15
Financial Markets
and Expectations
Prepared by:
Fernando Quijano and Yvonn Quijano
How Do Expectations Affect Asset
Prices?
• An asset is expected to provide a stream
of future payments to the owner.
• Putting aside speculative bubbles, the
value of an asset (its price) at any moment
in time is the expected present discounted
value of the stream of future payments.
How Do Expectations Affect Asset
Prices?
• Putting aside risk, the expected real return on all
assets should be the same; otherwise, investors
would be willing to hold only the asset with the
highest expected return.
• Since asset prices depend on expectations
about the future, they are greatly affected by
new information that changes these
expectations. Likewise, the more unexpected
an economic event—e.g., a monetary policy
decision—the greater its effect on asset prices.
Vocabulary
• This chapter introduces a large amount of
financial vocabulary.
• To really benefit from this chapter (and it
will be very useful knowledge), you should
try to memorize the Key Terms at the end
of the chapter and their meanings.
15-1
Bond Prices
and Bond Yields
• Bonds differ in two basic dimensions:
1. Default risk, the risk that the issuer of the
bond will not pay back the full amount
promised by the bond.
2. Maturity, the length of time over which the
bond promises to make payments to the
holder of the bond.
1. Also called “term” (e.g., a long-term bond is
one that matures many years after issuance).
Bond Prices
and Bond Yields
• Bonds of different maturities each have a
price
…and an associated interest rate, called
the yield to maturity, or simply the yield.
– If we arrange the yields of different
maturities, we can get a “yield curve.”
The Vocabulary of Bond Markets
• Government bonds are bonds issued by
government agencies.
• Corporate bonds are bonds issued by firms.
• Bond ratings are issued by Standard and
Poor’s Corporation and Moody’s Investors
Service.
• The risk premium is the difference between the
interest rate paid on a given bond and the
interest rate paid on the bond with the highest
rating.
The Vocabulary of Bond Markets
• Bonds with high default risk are often
called junk bonds.
• Bonds that promise a single payment at
maturity are called discount bonds. The
single payment is called the face value of
the bond.
• Bonds that promise multiple payments
before maturity and one payment at
maturity are called coupon bonds. The
payments are called coupon payments.
The Vocabulary of Bond Markets
• The ratio of the coupon payments to the
face value of the bond is called the
coupon rate.
• The coupon yield is the ratio of the
coupon payment to the price of the bond.
• The life of a bond is the amount of time
left until the bond matures.
The Vocabulary of Bond Markets
• U.S. government bonds classified by maturity:
– Treasury bills, or T-bills: Up to one year.
– Treasury notes: One to ten years.
– Treasury bonds: Ten years or more.
• Bonds typically promise to pay a sequence of
fixed nominal payments. However, other types
of bonds, called indexed bonds, promise
payments adjusted for inflation rather than fixed
nominal payments.
Bond Prices as Present Values
• Consider two types of bonds:
– A one-year bond—a bond that promises one
payment of $100 in one year.
– A two-year bond—a bond that promises one
payment of $100 in two years.
• Price of the one-year
• Price of the two-year
bond:
bond:
$100
$ P1t 
1  it
$100
$ P2 t 
(1  it )(1  i e 1t 1 )
Bond Prices as Present Values
• One-year bonds: For every dollar you
put in, you will get (1+ i1t) dollars next
year.
Bond Prices as Present Values
• Two-year bonds: For every dollar you
put in, you get a quantity $1/$P2t of twoyear bonds today.
A year later, your bond will have become
a one-year bond, of price $Pe1t+1.
If you sold the bond, you’d get $Pe1t+1
dollars times the quantity of two-year
bonds, $1/$P2t
So you can expect to get $Pe1t+1/$P2t next
year.
Arbitrage and Bond Prices
Returns from Holding One-Year and
Two-Year Bonds for One Year
For every dollar you put in
one-year bonds, you will get
(1+ i1t) dollars next year.
For every dollar you put in
two-year bonds, you can
expect to receive $1/$P2t
times $Pe1t+1 dollars next year.
• If you hold a two-year bond, the price at
which you will sell it next year is
uncertain—risky.
Arbitrage and Bond Prices
• The expectations hypothesis assumes that
investors care only about expected return.
– Ignores risk
• If two bonds offer the same expected one-year
return, then:
$ P e 1t 1
1  i1t 
$ P2 t
Return per dollar
from holding a
one-year bond for
one year.
Expected return
per dollar from
holding a two-year
bond for one year.
Arbitrage and Bond Prices
• Arbitrage relations are relations that make the
expected returns on two assets equal.
• Arbitrage implies that the price of a two-year
bond today is the present value of the
expected price of the bond next year.
e
$ P 1t 1
$ P2 t 
1  i1t
– The price of a two-year bond is the expected present
value of a one-year bond that you get next year.
Arbitrage and Bond Prices
• Arbitrage relations are relations that
make the expected returns on two assets
equal.
 The price of a one-year bond next year will
depend on the one-year rate next year.
$P
e
1t  1
$100

(1  i e 1t 1 )
 It’s the expected present value of $100,
discounted by one year at the future interest
rate.
Arbitrage and Bond Prices
• Given
$100
$ P 1t 1
e
and $ P 1t 1 
, then:
$ P2 t 
e
(1  i 1t 1 )
1  i1t
e
$100
$ P2 t 
(1  i1t )(1  i e 1t 1 )
In words, the price of two-year bonds is the present
value of the payment in two years—discounted using
current and next year’s expected one-year interest rate.
$100
$ P2 t 
(1  i1t )(1  i e 1t 1 )
TODAY
$P
e
1t  1
$100

(1  i e 1t 1 )
ONE YEAR
FROM
NOW
$100
TWO
YEARS
FROM
NOW
Arbitrage
• What is arbitrage?
– It is taking advantage of (small) price
differences between similar assets for quick
and certain profit.
• Suppose that
$100
$ P2t 
(1  i1t )(1  i1et 1 )
• Then a two-year bond is relatively cheap:
– someone can buy a two-year bond and earn a
higher return than if he put the same money in
a bank.
From Bond Prices to Bond Yields
• The yield to maturity on an n-year bond, or the
n-year interest rate, is the constant annual
interest rate that makes the bond price today
equal to the present value of future payments of
the bond.
$100
$100
$100
, then:
$ P2 t 

(1  i2 t ) (1  i1t )(1  i e 1t 1 )
1  i2 t
therefore:
$100
$100

(1  i2 t ) (1  i1t )(1  i e 1t 1 )
From here, we can solve for i2t.
From Bond Prices to Bond Yields
• The yield to maturity on a two-year bond, is
closely approximated by:
1
i2 t  (i1t  i e 1t 1 )
2
In words, the two-year interest rate is the average of
the current one-year interest rate and next year’s
expected one-year interest rate.
 Long-term interest rates reflect current and future
expected short-term interest rates.
Interpreting the Yield Curve
• An upward sloping yield curve means that
long-term interest rates are higher than
short-term interest rates. Financial
markets expect short-term rates to be
higher in the future.
• A downward sloping yield curve means
that long-term interest rates are lower than
short-term interest rates. Financial
markets expect short-term rates to be
lower in the future.
Bond Prices
and Bond Yields
U.S. Yield Curves:
November 1, 2000
and June 1, 2001
The yield curve, which
was slightly downward
sloping in November
2000, was sharply
upward sloping seven
months later.
 The relation between maturity and yield is called the
yield curve, or the term structure of interest rates.
The Yield Curve
and Economic Activity
The U.S. economy as
of November 2000
In November 2000, the
U.S. economy was
operating above the
natural level of output.
Forecasts were for a
“soft landing,” a return
of output to the natural
level of output, and a
small decrease in
interest rates.
The Yield Curve
and Economic Activity
The U.S. Economy
from November 2000
to June 2001
From November 2000 to
June 2001, an adverse
shift in spending,
together with a
monetary expansion,
combined to lead to a
decrease in the shortterm interest rate.
The Yield Curve
and Economic Activity
The Expected Path of
the U.S. Economy as
of June 2001
In June 2001, financial
markets expected
stronger spending and
tighter monetary policy
to lead to higher shortterm interest rates in the
future.
 The anticipation of higher short-term interest rates was the reason
why long-term interest rates remained high and why the yield
curve was upward sloping in June 2001.
Bond Prices
and Bond Yields
U.S. Yield Curves:
November 1, 2000
and June 1, 2001
The yield curve, which
was slightly downward
sloping in November
2000, was sharply
upward sloping seven
months later.
Expect small drop in rates
Sharp drop
in SR rates
Expect large rise in rates
The Stock Market and
Movements in Stock Prices
15-2
• Firms raise funds in two
ways:
1. Through debt finance—
bonds and loans; and
2. Through equity finance,
through issues of stocks—
or shares.
• Bonds pay predetermined
amounts; stocks pay
dividends from the firm’s
profits.
The Stock Market and
Movements in Stock Prices
Standard and
Poor’s Stock Price
Index in Nominal
and Real Terms,
1960-2000
Nominal stock prices
have multiplied by 25
since 1960. Real stock
prices have only
multiplied by 4. Real
stock prices went
through a slump until
the late 1980s. Only
since then have they
grown rapidly.
Stock Prices as Present Values
• The price of a stock must equal the
present value of future expected
dividends.
Stock Prices as Present Values
• The price of a stock must equal the
present value of future expected
dividends, or the present value of the
dividend next year, of two years from now,
and so on:
e
e
$ D t 1
$D t 2
$Qt 

 
e
(1  i1t ) (1  i1t )(1  i 1t 1 )
 In real terms,
$ D e t 1
$De t 2
$Qt 

 
e
(1  r1t ) (1  r1t )(1  r 1t 1 )
Stock Prices as Present Values
$ D e t 1
$De t 2
$Qt 

 
e
(1  r1t ) (1  r1t )(1  r 1t 1 )
• This relation has two important
implications:
– Higher expected future real dividends lead to
a higher real stock price.
– Higher current and expected future one-year
real interest rates lead to a lower real stock
price.
The Stock Market
and Economic Activity
• Largely, the movement of stock prices
is unpredictable. That is, each step
they take is as likely to be up as it is
to be down.
– We say stock prices follow a random
walk.
• Major movements in stock prices
cannot be predicted.
– But they can be explained.
A Monetary Expansion
and the Stock Market
An Expansionary
Monetary Policy and
the Stock Market
A monetary expansion
decreases the interest
rate and increases
output. What it does to
the stock market
depends on whether
financial markets
anticipated the monetary
expansion.
A Monetary Expansion
and the Stock Market
• If the monetary expansion was anticipated, the
market already “priced in” the expectation.
– It should have no effect.
e
e
$ D t 1
$D t2
$Qt 

 
e
(1  r1t ) (1  r1t )(1  r 1t 1 )
• If the market expected interest rates to fall by
less, stock prices should rise.
• If the market had expected interest rates to fall
by more, the surprise leads to lower stock
prices.
An Increase in Consumer
Spending and the Stock Market
An Increase in
Consumption
Spending and the
Stock Market
The increase in
consumption spending
leads to a higher interest
rate and a higher level
of output. What
happens to the stock
market depends on the
slope of the LM curve
and on the Fed’s
behavior.
An Increase in Consumer
Spending and the Stock Market
• Should higher C raise stock prices?
• If the LM curve is very flat, Y will increase by a
lot (increasing $D) and i will increase little,
leading to higher stock prices.
– And conversely.
$ D e t 1
$De t 2
$Qt 

 
(1  r1t ) (1  r1t )(1  r e 1t 1 )
• If the Fed “accommodates” to changes C by
expanding M to keep i constant, stock prices
should rise (Y rises).
– Conversely if the Fed raises interest rates to
counteract C.
An Increase in Consumer
Spending and the Stock Market
An Increase in
Consumption
Spending and the
Stock Market
If the LM curve is flat,
the interest rate
increases little, and
output increases a lot.
Stock prices go up.
If the LM curve is steep,
the interest rate
increases a lot, and
output increases little.
An Increase in Consumer
Spending and the Stock Market
An Increase in
Consumption
Spending and the
Stock Market
If the Fed
accommodates, the
interest rate does not
increase, but output
does. Stock prices go
up. If the Fed decides
instead to keep output
constant, the interest
rate increases, but
output does not. Stock
prices go down.
15-3
Bubbles, Fads,
and Stock Prices
• Stock prices are not always equal to
their fundamental value, or the present
value of expected dividends.
• Deviations of stock prices from their
fundamental value are called fads.
• Speculative bubbles may be rational if
stock prices increase just because
investors expected them to.