1. Prepared by: Fernando Quijano and Yvonn Quijano 15 C H A P T E R Financial Markets and Expectations

2. 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.

3. 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.

4. 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.

5. Bond Prices and Bond Yields 15-1 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).

6. 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.”

7. 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.

8. 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.

9. 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.

10. 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.

11. 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 bond: Price of the two-year bond:Price of the two-year bond:

12. Bond Prices as Present Values One-year bonds: For every dollar you put in, you will get (1+ i 1t ) dollars next year.

13. Bond Prices as Present Values Two-year bonds: For every dollar you put in, you get a quantity $1/$P 2t of two- year bonds today. A year later, your bond will have become a one-year bond, of price $P e 1t+1. If you sold the bond, you’d get $P e 1t+1 dollars times the quantity of two-year bonds, $1/$P 2t So you can expect to get $P e 1t+1 /$P 2t next year.

14. Arbitrage and Bond Prices If you hold a two-year bond, the price at which you will sell it next year is uncertain—risky. For every dollar you put in one-year bonds, you will get (1+ i 1t ) dollars next year. For every dollar you put in two-year bonds, you can expect to receive $1/$P 2t times $P e 1t+1 dollars next year. Returns from Holding One-Year and Two-Year Bonds for One Year

15. 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: 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.

16. 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 two-year bond is the expected present value of a one-year bond that you get next year.

17. 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.  It’s the expected present value of $100, discounted by one year at the future interest rate.

18. Arbitrage and Bond Prices Given and, then: 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.

19. TODAYONE YEAR FROM NOW TWO YEARS FROM NOW $100

20. What is arbitrage? –It is taking advantage of (small) price differences between similar assets for quick and certain profit. Suppose that 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. Arbitrage

21. 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 i 2t.

22. 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 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.

23. 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.

24. 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.

25. 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.

26. 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 short- term interest rate.

27. 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 short- term 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.

28. 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. Sharp drop in SR rates Expect small drop in rates Expect large rise in rates

29. 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.

30. 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.

31. Stock Prices as Present Values The price of a stock must equal the present value of future expected dividends.

32. 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,

33. 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.

34. 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.

35. 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.

36. 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. 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.

37. 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.

38. 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. 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.

39. 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.

40. 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.

41. Bubbles, Fads, and Stock Prices 15-3 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.