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CHAPTER 15 CHAPTER15 Financial Markets and Expectations Prepared by: Fernando Quijano and Yvonn Quijano © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard Chapter 15: Financial Markets and Expectations 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. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 2 of 33 Chapter 15: Financial Markets and Expectations Bond Prices and Bond Yields 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. The relation between maturity and yield is called the yield curve, or the term structure of interest rates. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 3 of 33 Chapter 15: Financial Markets and Expectations 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. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 4 of 33 Chapter 15: Financial Markets and Expectations 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. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 5 of 33 Chapter 15: Financial Markets and Expectations The Vocabulary of Bond Markets 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. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 6 of 33 Chapter 15: Financial Markets and Expectations 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. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 7 of 33 Chapter 15: Financial Markets and Expectations 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: $100 $ P1t 1 i1t © 2006 Prentice Hall Business Publishing Price of the two-year bond: $100 $ P2 t (1 i1t )(1 i e 1t 1 ) Macroeconomics, 4/e Olivier Blanchard 8 of 33 Chapter 15: Financial Markets and Expectations Arbitrage and Bond Prices Figure 15 - 1 Returns from Holding 1-Year and 2-Year Bonds for 1 Year © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 9 of 33 Chapter 15: Financial Markets and Expectations 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. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 10 of 33 Chapter 15: Financial Markets and Expectations 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: 1 i1t Return per dollar from holding a one-year bond for one year. © 2006 Prentice Hall Business Publishing $ P e 1t 1 $ P2 t Expected return per dollar from holding a two-year bond for one year. Macroeconomics, 4/e Olivier Blanchard 11 of 33 Chapter 15: Financial Markets and Expectations 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. $ 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 © 2006 Prentice Hall Business Publishing e 1t 1 $100 (1 i e 1t 1 ) Macroeconomics, 4/e Olivier Blanchard 12 of 33 Chapter 15: Financial Markets and Expectations Arbitrage and Bond Prices $100 $ P e 1t 1 e Given $ P2 t and $ P 1t 1 , then: e (1 i 1t 1 ) 1 i1t $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. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 13 of 33 Chapter 15: Financial Markets and Expectations 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. $100 $100 $100 , then: $ P2 t 2 2 (1 i2 t ) (1 i1t )(1 i e 1t 1 ) (1 i2 t ) e ( 1 i ) ( 1 i )( 1 i therefore: 1t 1 ) 2t 1t From here, we can solve for i2t. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 14 of 33 Chapter 15: Financial Markets and Expectations From Bond Prices to Bond Yields The yield to maturity on a two-year bond, is closely approximated by: 1 e i2 t (i1t i1t 1 ) 2 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. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 15 of 33 Chapter 15: Financial Markets and Expectations Interpreting the Yield Curve An upward sloping yield curve means that longterm interest rates are higher than short-term interest rates. Financial markets expect shortterm rates to be higher in the future. A downward sloping yield curve means that longterm interest rates are lower than short-term interest rates. Financial markets expect shortterm 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 2t 1t © 2006 Prentice Hall Business Publishing i Macroeconomics, 4/e 2i i Olivier Blanchard 16 of 33 Chapter 15: Financial Markets and Expectations The Yield Curve and Economic Activity Figure 15 - 3 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. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 17 of 33 Chapter 15: Financial Markets and Expectations The Yield Curve and Economic Activity Figure 15 - 4 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. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 18 of 33 Chapter 15: Financial Markets and Expectations 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. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 19 of 33 Chapter 15: Financial Markets and Expectations The Yield Curve and Economic Activity Figure 15 - 5 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 shortterm interest rates in the future. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 20 of 33 Chapter 15: Financial Markets and Expectations 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. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 21 of 33 Chapter 15: Financial Markets and Expectations The Stock Market and Movements 15-2 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. Bonds pay predetermined amounts; stocks pay dividends from the firm’s profits. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 22 of 33 Chapter 15: Financial Markets and Expectations The Stock Market and Movements in Stock Prices Figure 15 - 6 Standard and Poor’s Stock Price Index, in Real Terms since 1980 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. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 23 of 33 Chapter 15: Financial Markets and Expectations 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: e e $ D t 1 $D t 2 $Qt e (1 i1t ) (1 i1t )(1 i 1t 1 ) In real terms, D e t 1 De t 2 Qt e (1 r1t ) (1 r1t )(1 r 1t 1 ) © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 24 of 33 Chapter 15: Financial Markets and Expectations Stock Prices as Present Values e e D t 1 D t2 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. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 25 of 33 Chapter 15: Financial Markets and Expectations 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. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 26 of 33 Chapter 15: Financial Markets and Expectations A Monetary Expansion and the Stock Market 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. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 27 of 33 Chapter 15: Financial Markets and Expectations An Increase in Consumer Spending and the Stock Market Figure 15 –8 (a) 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. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 28 of 33 Chapter 15: Financial Markets and Expectations An Increase in Consumer Spending and the Stock Market Figure 15 – 8(b) 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. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 29 of 33 Chapter 15: Financial Markets and Expectations An Increase in Consumer Spending and the Stock Market Figure 15 – 8(c) 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. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 30 of 33 Chapter 15: Financial Markets and Expectations 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. 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. © 2006 Prentice Hall Business Publishing Making (Some) Sense of (Apparent) Nonsense: Why the Stock Market Moved Yesterday, and Other Stories Try to make sense of these quotes from The Wall Street Journal. Macroeconomics, 4/e Olivier Blanchard 31 of 33 Chapter 15: Financial Markets and Expectations 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. © 2006 Prentice Hall Business Publishing Famous Bubbles: From Tulipmania in SeventeenthCentury Holland to Russia in 1994. Two accounts of fads, tulips and worthless stocks, that eventually flopped. Macroeconomics, 4/e Olivier Blanchard 32 of 33 Chapter 15: Financial Markets and Expectations Key Terms default risk maturity yield curve 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, or T-bills © 2006 Prentice Hall Business Publishing 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 Macroeconomics, 4/e Olivier Blanchard 33 of 33