Intermediate Macroeconomics Chapter 17 Financial Markets

Intermediate Macroeconomics Financial Markets Three Markets: –Bond Market (yield curve) –Stock Market (random walk) –Foreign Exchange Market (exchange rates and interest rates) Key Concepts: –Forward Looking –Arbitrage

Intermediate Macroeconomics Arbitrage In equilibrium, investors must be equally willing to buy or sell an asset. There must be no unrealized profit (arbitrage) opportunities

Intermediate Macroeconomics Bond Market Price of a Bond Term Structure of Interest Rates Typical Market Conditions Normal Yield Curve Inverted Yield Curve Interest Rate Volatility

Intermediate Macroeconomics Price of a Bond Price = net present value of bond’s cash-in value (forward looking) =bond face value discounted by nominal interest rate Long-Term Nominal Interest Rate =average of current and expected future short-term interest rates Term of a Bond = years to maturity

Intermediate Macroeconomics Term Structure of Interest Rates Term Structure - relationship between short-term interest rate (rate on a 6- month T-Bill) and long-term interest rate (rate on a 30-year T-Bill) –Normal Yield Curve : long-term interest rates are higher –Flat Yield Curve : short-term and long- term interest rates are identical –Inverted Yield Curve : short-term interest rates are higher

Intermediate Macroeconomics Interest Rate Term Premium 30 year T-Bill - 1 year T-Bill Oct Feb Mar. 1980

Intermediate Macroeconomics T-Bill Yield Curve Mar Oct Feb. 2000

Intermediate Macroeconomics Variables that influence Term Structure Expected Inflation –Normal curve - expect increase in inflation rate –Inverted curve - expect decline in inflation rate Relative Risk –normal curve - longer term assets are riskier require higher rate of return –inverted curve - short term rates are more volatile

Intermediate Macroeconomics Stock Price Random Walk Price of a Stock Changes in Stock Market Prices –unexpected changes in market information Implications –expected economic growth –technological innovation –you can’t outperform the market Typical Market Conditions –stock price volatility –stocks outperform bonds