1. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 16-1 Chapter 16 Financial Markets

2. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 16-2 Objectives Explain why financial markets are forward-looking Understand the concept of arbitrage Discuss the link between short-term and long-term interest rates Link exchange rates to interest rates

3. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 16-3 Chapter Organisation 16.1Interest Rates: Long Term and Short 16.2The Random Walk of Share Prices 16.3Exchange Rates and Interest Rates

4. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 16-4 Financial Markets Three financial markets are considered: –The bond market –The share market –The foreign exchange market.

5. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 16-5 Financial Markets In each case, the analysis begins with two assumptions: –Markets are forward-looking. –The presence of arbitrage implies that in equilibrium, prices must make investors equally willing to buy or sell an asset. Any price other than equilibrium will place everyone on only one side of the market.

6. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 16-6 16.1 Interest Rates: Long Term and Short Previously, we assumed that there was a single interest rate, i. However, interest rates differ according to factors associated with a bond or loan: –Creditworthiness of the issuer –Tax treatments –Risk and uncertainty –The term of the bond.

7. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 16-7 Interest Rates: Long Term and Short Our analysis focuses on the length of time the interest rate covers (maturity of the bond). The relation between interest rates on different maturities is called the 'term structure of investment'. The interest rate on a 10-year bond is usually higher than for a 1-year bond.

8. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 16-8 Interest Rates: Long Term and Short The cash rate is a short-term interest rate. Variable rate housing loans and 10-year bonds are long-term interest rates. In Figure 16.1 three patterns emerge: –Interest rates of different maturities fluctuate together. –The gap between long-term and short-term rates vary. –Long-term rates are usually higher than short-term rates.

9. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 16-9 Interest Rates: Long Term and Short

10. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 16-10 Interest Rates: Long Term and Short An example of the relationship between short- and long-term interest rates: –Assume you can buy either a 1-year or 3-year bond at the start of the year 2005. –You can invest for 1 year at the 2005 rate, reinvest for another year at the 2006 rate, and then reinvest for a final year at the 2007 rate. –If all the rates for 2005 and 2007 were known in advanced, the total return is 1 i 2005 + 1 i 2006 + 1 i 2007

11. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 16-11 Interest Rates: Long Term and Short –Alternatively you can make a 3-year investment today and earn 3  3 i 2005 –The presence of arbitrage ensures that the 3-year investment must equal the return from the series of three 1-year investments 3  3 i 2005 = 1 i 2005 + 1 i 2006 + 1 i 2007 –We can rewrite this condition as the average 3 i 2005 = ( 1 i 2005 + 1 i 2006 + 1 i 2007 )/3

12. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 16-12 Interest Rates: Long Term and Short Arbitrage is the practice of buying or selling of assets in order to take advantage of differences in returns.

13. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 16-13 Interest Rates: Long Term and Short The preceding example implies that the long-term interest rate equals the average current and future short-term interest rates. The problem with this model is that we are uncertain about future short-term interest rates. Hence, two modifications are required with the model.

14. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 16-14 Interest Rates: Long Term and Short Today’s long-term rate depends on the current short-term rate and expected future short-term rates. Uncertainty implies risk, and long-term investments command a term premium (PR) to compensate for the risk. Incorporating this into our model gives Equation (16.1).

15. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 16-15 Interest Rates: Long Term and Short 3 i 2 005 = ( 1 i 2005 + 1 i e 2006 + 1 i e 2007 )/3 + PR(16.1) where the e superscript indicates the expectation of future short-term interest rates Equation (16.1) shows the expectations theory of the term structure. –Higher-term premiums compensate (reflect) the higher risk associated with the greater price volatility for longer-term bonds.

16. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 16-16 The Yield Curve Interest rates for different maturities are shown on a yield curve. Figure 16.3 shows the yield curves for 1989 and 1999. –Yield curves usually rise with maturity as for 1999. –However, there are exceptions—as for 1989, where short rates are above long rates. –This means markets expect interest rates to fall.

17. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 16-17 The Yield Curve

18. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 16-18 Bond Prices and Yields Most bonds make a periodic payment called a coupon and then return the bond’s face value at maturity. Bond prices are inversely related to interest rates. –Consider a bond with a face value of $100 a year from now and with interest rate: i = 5% –Its price P is given by: P(1 + i) = 100 –  P = 100/(1 + 0.05) = $95.24

19. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 16-19 Bond Prices and Yields Now consider a bond of T periods with coupon payments of $c per period and final face value $F at the end of period T. –The price P of the bond is the NPV (discounted by the interest rate i) of c and F –P = c(1 + i ) -1 + ….. + c(1 + i ) -T + F(1 + i ) -T For a 2-year bond with $5 coupons, 5% interest and $100 maturity after 2 years: P= $5(1 + 0.05) -1 + $5(1 + 0.05) -2 + $100(1 + 0.05) -2 = $100 (par value)

20. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 16-20 Bond Prices and Yields Suppose that, after purchasing the bond, interest rates increase to 10%. –To sell the bond, the price must fall to compensate the new buyer for receiving $5 coupons instead of $10 with a new bond. –Hence, the price of the old bond is now P= $5(1.10) -1 + $5(1.10) -2 + $100(1.10) -2 = $91.32 < $100. –A longer remaining term of the bond requires a larger compensatory fall in price.

21. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 16-21 Chapter Organisation 16.1Interest Rates: Long Term and Short 16.2The Random Walk of Share Prices 16.3Exchange Rates and Interest Rates

22. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 16-22 16.2 The Random Walk of Share Prices The share market is a major form of accumulating wealth. There is a link between the share market and the IS curve (since wealth affects consumption). An established fact is that changes in share prices are essentially unpredictable. The Australian All Ordinaries Index is a function of its previous period value.

23. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 16-23 The Random Walk of Share Prices

24. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 16-24 The Random Walk of Share Prices Figure 16.4 indicates that the data is tightly scattered around the 45 0 line. Equation (16.2) is the equation for the 45 0 line. P t+1 = a + P t +  (16.2) a  represents the expected return to share holdings and is quite small  represents the surprise change in share prices

25. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 16-25 The Random Walk of Share Prices The process described by Equation (16.2) is known as a 'random walk'. The concept of the random walk refers a variable in which changes over time are unpredictable.

26. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 16-26 The Random Walk of Share Prices Implications of this random walk: –Aside from the very small expected return, a, the changes in share prices are unpredictable. –Following a shock, share prices do not have a tendency to return to ‘normal’ levels. –Rather, changes to share prices are independent over time. –So if shares did well last month, they are no more likely to do well or do poorly this month. –This random walk is a sign of market efficiency.

27. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 16-27 Chapter Organisation 16.1Interest Rates: Long Term and Short 16.2The Random Walk of Share Prices 16.3Exchange Rates and Interest Rates

28. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 16-28 16.3 Exchange Rates and Interest Rates Arbitrage links exchange rates to international interest rate differentials. Example –Assume an American has two investment strategies to invest US$100 for 1 year.  Strategy 1: Invest in the US  Strategy 2: Convert US$100 to Australian dollars, invest in Australia for a year, and then convert back to US dollars at year end.

29. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 16-29 Exchange Rates and Interest Rates –The return for Strategy 1 is:  100  (1 + i ) dollars. For a US interest rate of 10% the investor has US$110 at period end. –To execute Strategy 2 involves a few steps:  Convert US$100 to Australian dollars using the exchange rate e t gives A$100/e t  For Australian interest rate i *, the investor will have (100/e t ) x (1 + i *) Australian dollars at the end of the year.

30. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 16-30 Exchange Rates and Interest Rates –Also at the end of the year, the A$ are converted back to US$ using the prevailing exchange rate e t+1 –The final end-of-year return in $US is e t + 1 x [(100)/)  (1 + i *)] –For Strategies 1 and 2 to have equal returns requires [(1 + i ) = (e t + 1 /e t )  (1 + i *)] –Rearranging this identity gives Equation (16.7):

31. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 16-31 Exchange Rates and Interest Rates The expected percentage appreciation of the exchange rate will be equal to the interest rate differential. The equation is called uncovered interest rate parity (UIP). It is ‘uncovered’ because there is a risk involved as the end of year exchange rate is not known with certainty.

32. Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 16-32 Exchange Rates and Interest Rates The risk can be eliminated by selling the A$ for US$ at the start of the year for delivery at year end. This use of the forward foreign exchange market gives ‘covered’ interest parity (CIP).