Transcript Document

Financial
Financial Markets
Markets
and
and Expectations
Expectations
CHAPTER 15
Prepared by:
Fernando Quijano and Yvonn Quijano
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Macroeconomics, 5/e • Olivier Blanchard
15-1 Bond Prices and Bond Yields
Bonds differ in two basic dimensions:
Chapter 15: Financial Markets and Expectations
 Default risk, the risk that the issuer of the bond
will not pay back the full amount promised by
the bond.
 Maturity, the length of time over which the bond
promises to make payments to the holder of the
bond.
Bonds of different maturities each have a price and
an associated interest rate called the yield to
maturity, or simply the yield.
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15-1 Bond Prices and Bond Yields
Chapter 15: Financial Markets and Expectations
The relation between maturity and yield is called the
yield curve, or the term structure of interest rates.
Figure 15 - 1
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.
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The Vocabulary of Bond Markets
Chapter 15: Financial Markets and Expectations
 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.
Bonds with high default risk are often called junk
bonds.
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The Vocabulary of Bond Markets
Chapter 15: Financial Markets and Expectations
 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 ratio of the coupon payments to the face value of
the bond is called the coupon rate.
The current 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.
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The Vocabulary of Bond Markets
Chapter 15: Financial Markets and Expectations
 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.
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15-1 Bond Prices and Bond Yields
Bond Prices as Present Values
Consider two types of bonds:
Chapter 15: Financial Markets and Expectations
 A one-year bond—a bond that promises one payment
of $100 in one year. Price of the one-year bond:
$100
$ P1t 
1  i1t
 A two-year bond—a bond that promises one payment
of $100 in two years. Price of the two-year bond:
$100
$ P2 t 
(1  i1t )(1  i e 1t 1 )
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15-1 Bond Prices and Bond Yields
Arbitrage and Bond Prices
Chapter 15: Financial Markets and Expectations
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.
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15-1 Bond Prices and Bond Yields
Arbitrage and Bond Prices
Chapter 15: Financial Markets and Expectations
Figure 15 - 2
Returns from Holding
One-Year and Two-Year
Bonds for One Year
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15-1 Bond Prices and Bond Yields
Arbitrage and Bond Prices
The expectations hypothesis states that investors care
only about expected return.
Chapter 15: Financial Markets and Expectations
If two bonds offer the same expected one-year return, then:
1  i1t

Return per dollar
from holding a
one-year bond for
one year.
$ P e 1t 1
$ P2 t
Expected return
per dollar from
holding a two-year
bond for one year.
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15-1 Bond Prices and Bond Yields
Arbitrage and Bond Prices
Chapter 15: Financial Markets and Expectations
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.
$ P e 1t 1
$ P2 t 
1  i1t
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 )
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15-1 Bond Prices and Bond Yields
Arbitrage and Bond Prices
Chapter 15: Financial Markets and Expectations
Given
$ P e 1t 1
$ P2 t 
1  i1t
and
$P
e
1t  1
$100

(1  i e 1t 1 )
, then:
$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.
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15-1 Bond Prices and Bond Yields
From Bond Prices to Bond Yields
Chapter 15: Financial Markets and Expectations
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
$ P2 t 
(1  i2 t ) 2
therefore:
, then:
1  i2t 
2
$100
$100
2 
(1  i2 t )
(1  i1t )(1  i e 1t 1 )

 1  i1t  1  i1et 1

From here, we can solve for i2t.
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15-1 Bond Prices and Bond Yields
From Bond Prices to Bond Yields
Chapter 15: Financial Markets and Expectations
The yield to maturity on a two-year bond, is closely
approximated by:
i2 t
1
e
 (i1t  i1t 1 )
2
In words, the two-year interest rate is (approximately)
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.
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15-1 Bond Prices and Bond Yields
Interpreting the Yield Curve
Chapter 15: Financial Markets and Expectations
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.
Using the following equation, you can fine out what financial
markets expect the 1-year interest rate to be 1 year from
now:
e
1t 1
i
 2i2t  i1t
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15-1 Bond Prices and Bond Yields
The Yield Curve and Economic Activity
Figure 15 - 3
Chapter 15: Financial Markets and Expectations
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.
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15-1 Bond Prices and Bond Yields
The Yield Curve and Economic Activity
Figure 15 - 4
Chapter 15: Financial Markets and Expectations
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
short-term interest rate.
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15-1 Bond Prices and Bond Yields
The Yield Curve and Economic Activity
Chapter 15: Financial Markets and Expectations
From this figure, you can see
the two major developments:
 The adverse shift in
spending was stronger than
had been expected. Instead
of shifting from IS to IS’ as
forecast, the IS curve
shifted by much more, to
IS’’.
 Realizing that the
slowdown was stronger
than it had anticipated, the
Fed shifted in early 2001 to
a policy of monetary
expansion, leading to a
downward shift in the LM
curve.
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15-1 Bond Prices and Bond Yields
The Yield Curve and Economic Activity
Figure 15 - 5
Chapter 15: Financial Markets and Expectations
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 short-term
interest rates in the future.
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15-1 Bond Prices and Bond Yields
The Yield Curve and Economic Activity
Chapter 15: Financial Markets and Expectations
Financial markets
expected two main
developments:
 They expected a
pickup in spending-a
shift of the IS curve to
the right, from IS to
IS’.
 They also expected
that, once the IS
curve started shifting
to the right and
output started to
recover, the Fed
would start shifting
back to a tighter
monetary policy.
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15-2 The Stock Market and Movements
in Stock Prices
Firms raise funds in two ways:
Chapter 15: Financial Markets and Expectations
 Through debt finance —bonds and loans;
and
 Through equity finance, through issues of
stocks—or shares. Instead of paying
predetermined amounts as bonds do, stocks
pay dividends in an amount decided by the
firm.
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15-2 The Stock Market and Movements
in Stock Prices
Figure 15 - 6
Chapter 15: Financial Markets and Expectations
Standard & Poor’s
Composite Index, in
Real Terms, since 1980
Note the sharp increase in
stock prices in the 1990s,
followed by the sharp
decrease in the early
2000s.
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15-2 The Stock Market and Movements
in Stock Prices
Stock Prices as Present Values
Chapter 15: Financial Markets and Expectations
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:
$ Dte1
$ Dte 2
$Qt 

 ...
e
1  i1t 1  i1t  1  i1t 1


In real terms,
Dte1
Dte 2
Qt 

 ...
e
1  r1t  1  r1t  1  r1t 1e


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15-2 The Stock Market and Movements
in Stock Prices
Stock Prices as Present Values
Chapter 15: Financial Markets and Expectations
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.
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15-2 The Stock Market and Movements
in Stock Prices
The Stock Market and Economic Activity
Chapter 15: Financial Markets and Expectations
Stock prices follow a random walk if each step they take
is as likely to be up as it is to be down. Their movements
are therefore unpredictable.
Even though major movements in stock prices cannot be
predicted, we can still do two things:
 We can look back and identify the news to which the
market reacted.
 We can ask “what if” questions.
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15-2 The Stock Market and Movements
in Stock Prices
The Stock Market and Economic Activity
A Monetary Expansion and the Stock Market
Chapter 15: Financial Markets and Expectations
Figure 15 - 7
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.
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15-2 The Stock Market and Movements
in Stock Prices
The Stock Market and Economic Activity
An Increase in Consumer Spending and the Stock Market
Chapter 15: Financial Markets and Expectations
Figure 15 – 8a
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.
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15-2 The Stock Market and Movements
in Stock Prices
The Stock Market and Economic Activity
An Increase in Consumer Spending and the Stock Market
Chapter 15: Financial Markets and Expectations
Figure 15 – 8b
An Increase in
Consumption Spending
and the Stock Market
If the LM curve is steep, the
interest rate increases a lot,
and output increases little.
Stock prices go down. If the
LM curve is flat, the interest
rate increases little, and
output increases a lot. Stock
prices go up.
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15-2 The Stock Market and Movements
in Stock Prices
The Stock Market and Economic Activity
An Increase in Consumer Spending and the Stock Market
Chapter 15: Financial Markets and Expectations
Figure 15 – 8c
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.
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15-2 The Stock Market and Movements
in Stock Prices
The Stock Market and Economic Activity
An Increase in Consumer Spending and the Stock Market
Chapter 15: Financial Markets and Expectations
There are several things the Fed may do after receiving news
of strong economic activity:
 They may accommodate, or increase the money supply in
line with money demand so as to avoid an increase in the
interest rate. An example of Fed accommodation is
shown in Figure 15-8(c).
 They may keep the same monetary policy, leaving the LM
curve unchanged causing the economy to move along the
LM curve.
 Or the Fed may worry that an increase in output above YA
may lead to an increase in inflation.
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Making (Some) Sense of (Apparent) Nonsense: Why the
Stock Market Moved Yesterday and Other Stories
Chapter 15: Financial Markets and Expectations
Here are some quotes from the Wall Street Journal from April 1997 to
August 2001. Try to make sense of them, using what you’ve just
learned:
 April 1997.Good news on the economy, leading to an increase in
stock prices: “Bullish investors celebrated the release of marketfriendly economic data by stampeding back into stock and bond
markets, pushing the Dow Jones Industrial Average to its secondlargest point gain ever and putting the blue-chip index within
shooting distance of a record just weeks after it was reeling.”
 December 1999.Good news on the economy, leading to a decrease
in stock prices: “Good economic news was bad news for stocks and
worse news for bonds. . . . The announcement of stronger-thanexpected November retail-sales numbers wasn’t welcome.
Economic strength creates inflation fears and sharpens the risk that
the Federal Reserve will raise interest rates again.”
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Making (Some) Sense of (Apparent) Nonsense: Why the
Stock Market Moved Yesterday and Other Stories
Chapter 15: Financial Markets and Expectations
 September 1998. Bad news on the economy, leading to an decrease
in stock prices: “Nasdaq stocks plummeted as worries about the
strength of the U.S. economy and the profitability of U.S.
corporations prompted widespread selling.”
 August 2001. Bad news on the economy, leading to an increase in
stock prices: “Investors shrugged off more gloomy economic news,
and focused instead on their hope that the worst is now over for both
the economy and the stock market. The optimism translated into
another 2% gain for the Nasdaq Composite Index.”
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15-3 Bubbles, Fads, and Stock Prices
Chapter 15: Financial Markets and Expectations
Stock prices are not always equal to their
fundamental value, or the present value of
expected dividends.
Rational speculative bubbles occur when stock
prices increase just because investors expected
them to.
Deviations of stock prices from their fundamental
value are called fads.
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Famous Bubbles: From Tulipmania in SeventeenthCentury Holland to Russia in 1994
Chapter 15: Financial Markets and Expectations
Tulipmania in Holland
In the seventeenth century, tulips became increasingly popular in
western European gardens. A market developed in Holland for
both rare and common forms of tulip bulbs.
The MMM Pyramid in Russia
In 1994 a Russian “financier,” Sergei Mavrody, created a
company called MMM and proceeded to sell shares, promising
shareholders a rate of return of at least 3,000% per year!
The trouble was that the company was not involved in any type
of production and held no assets, except for its 140 offices in
Russia. The shares were intrinsically worthless. The company’s
initial success was based on a standard pyramid scheme, with
MMM using the funds from the sale of new shares to pay the
promised returns on the old shares.
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Chapter 15: Financial Markets and Expectations
Key Terms
 default risk
 maturity
 yield curve or term structure
of interest rates
 government bonds
 corporate bonds
 bond ratings
 risk premium
 junk bonds
 discount bonds
 face value
 coupon bonds
 coupon payments
 coupon rate
 current yield
 life (of a bond)
 Treasury bills (T-bills)








Treasury notes
Treasury bonds
indexed bonds
expectations hypothesis
arbitrage
yield to maturity, or n-year
interest rate
soft landing
debt finance








equity finance
shares, or stocks
dividends
random walk
Fed accommodation
fundamental value
rational speculative bubbles
fads
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