15-1 Bond Prices and Bond Yields Bonds differ in two basic dimensions: 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.

15-1 Bond Prices and Bond Yields The relation between maturity and yield is called the yield curve, or the term structure of interest rates. U.S.Yield Curves: November 1, 2000, and June 1, 2001 Figure 15 - 1 The yield curve, which was slightly downward sloping in November 2000, was sharply upward sloping seven months later.

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. Bonds with high default risk are often called junk bonds.

The Vocabulary of Bond Markets 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.

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.

15-1 Bond Prices and Bond Yields 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. Price of the one-year bond: A two-year bond—a bond that promises one payment of $100 in two years. Price of the two-year bond:

15-1 Bond Prices and Bond Yields Arbitrage and Bond Prices 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.

15-1 Bond Prices and Bond Yields Arbitrage and Bond Prices Returns from Holding One-Year and Two-Year Bonds for One Year Figure 15 - 2

15-1 Bond Prices and Bond Yields Arbitrage and Bond Prices The expectations hypothesis states that investors care only about expected return. If two bonds offer the same expected one-year return, then: 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.

15-1 Bond Prices and Bond Yields 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. The price of a one-year bond next year will depend on the one-year rate next year.

15-1 Bond Prices and Bond Yields Arbitrage and Bond Prices , then: Given and 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.

15-1 Bond Prices and Bond Yields 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. , then: therefore: From here, we can solve for i2t.

15-1 Bond Prices and Bond Yields From Bond Prices to Bond Yields The yield to maturity on a two-year bond, is closely approximated by: 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.

15-1 Bond Prices and Bond Yields 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. Using the following equation, you can fine out what financial markets expect the 1-year interest rate to be 1 year from now:

15-1 Bond Prices and Bond Yields The Yield Curve and Economic Activity The U.S. Economy as of November 2000 Figure 15 - 3 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.

15-1 Bond Prices and Bond Yields The Yield Curve and Economic Activity The U.S. Economy from November 2000 to June 2001 Figure 15 - 4 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.

15-1 Bond Prices and Bond Yields The Yield Curve and Economic Activity 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.

15-1 Bond Prices and Bond Yields The Yield Curve and Economic Activity The Expected Path of the U.S. Economy as of June 2001 Figure 15 - 5 In June 2001, financial markets expected stronger spending and tighter monetary policy to lead to higher short-term interest rates in the future.

15-1 Bond Prices and Bond Yields The Yield Curve and Economic Activity 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.

15-2 The Stock Market and Movements in Stock Prices Firms raise funds in two ways: 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.

15-2 The Stock Market and Movements in Stock Prices Standard & Poor’s Composite Index, in Real Terms, since 1980 Figure 15 - 6 Note the sharp increase in stock prices in the 1990s, followed by the sharp decrease in the early 2000s.

15-2 The Stock Market and Movements in Stock Prices 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: In real terms,

15-2 The Stock Market and Movements in Stock Prices Stock Prices as Present Values 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.

15-2 The Stock Market and Movements in Stock Prices The Stock Market and Economic Activity 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.

15-2 The Stock Market and Movements in Stock Prices The Stock Market and Economic Activity A Monetary Expansion and the Stock Market An Expansionary Monetary Policy and the Stock Market Figure 15 - 7 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.

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 An Increase in Consumption Spending and the Stock Market Figure 15 – 8a 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.

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 An Increase in Consumption Spending and the Stock Market Figure 15 – 8b 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.

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 An Increase in Consumption Spending and the Stock Market Figure 15 – 8c 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.

15-2 The Stock Market and Movements in Stock Prices The Stock Market and Economic Activity An Increase in Consumer Spending and the Stock Market 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.

Making (Some) Sense of (Apparent) Nonsense: Why the Stock Market Moved Yesterday and Other Stories 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 market-friendly economic data by stampeding back into stock and bond markets, pushing the Dow Jones Industrial Average to its second-largest 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-than-expected 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.”

Making (Some) Sense of (Apparent) Nonsense: Why the Stock Market Moved Yesterday and Other Stories 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.”

15-3 Bubbles, Fads, and Stock Prices 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.

Famous Bubbles: From Tulipmania in Seventeenth-Century Holland to Russia in 1994 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.

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