ch15 4e

CHAPTER 15
CHAPTER15
Financial Markets
and Expectations
Prepared by:
Fernando Quijano and Yvonn Quijano
2006 Prentice Hall Business Publishing
Macroeconomics, 4/e
Olivier
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.
Macroeconomics, 4/e
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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.
Macroeconomics, 4/e
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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 Poors
Corporation and Moodys 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.
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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.
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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.
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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.
Macroeconomics, 4/e
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Expectations
Bond Prices as Present Values
Consider two types of bonds:

A one-year bonda bond that promises one
payment of $100 in one year.
A two-year bonda bond that promises one
payment of $100 in two years.
Price of the one-year
bond:
$ P1t
Price of the two-year bond:
$100
1 i1t
$ P2t
$100
(1 i1t ) (1 i e 1t1 )
Macroeconomics, 4/e
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Expectations
Arbitrage and Bond Prices
Figure 15 - 1
Returns from Holding
1-Year and 2-Year
Bonds for 1 Year
Macroeconomics, 4/e
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Expectations
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 uncertainrisky.
Macroeconomics, 4/e
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Expectations
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.
$ P e 1t1
$ P2t
Expected return
per dollar from
holding a two-year
bond for one year.
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Expectations
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.
$ P2t
$ P e 1t1
1 i1t
The price of a one-year bond next year will

depend on the one-year rate next year.
$ P
1t1
$100
(1 i e 1t1 )
Macroeconomics, 4/e
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Expectations
Given $ P 2 t
$ P e 1t1
and $ P
1 i1t
$ P2t
1t1
$100
, then:
e
(1 i 1t1 )
$100
(1 i1t ) (1 i e 1t1 )
In words, the price of two-year bonds is the

present value of the payment in two years
discounted using current and next years
expected one-year interest rate.
Macroeconomics, 4/e
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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.
$ P2t
$100
$100
$100
, then:
2
2
(1 i2 t )
(1 i2 t )
(1 i1t ) (1 i e 1t1 )
e
(
1
i
)
(
1
i
)
(
1
i
therefore:
1t1 )
2t
1t
From here, we can solve for i2t.
Macroeconomics, 4/e
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Expectations
From Bond Prices to Bond Yields
The yield to maturity on a two-year bond, is

closely approximated by:
i2 t
1
e
( i1 t i 1 t 1 )
2
In words, the two-year interest rate is the

average of the current one-year interest rate and
next years expected one-year interest rate.
Long-term interest rates reflect current and future
expected short-term interest rates.
Macroeconomics, 4/e
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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
1t1
2t
1t
2i
Macroeconomics, 4/e
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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.
Macroeconomics, 4/e
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Expectations
The Yield Curve

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.
Macroeconomics, 4/e
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Expectations
The Yield Curve

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.
Macroeconomics, 4/e
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Expectations
The Yield Curve

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.
Macroeconomics, 4/e
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Expectations
The Yield Curve

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.
Macroeconomics, 4/e
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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 stocksor shares.
Bonds pay predetermined
amounts; stocks pay dividends
from the firms profits.
Macroeconomics, 4/e
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Expectations
The Stock Market and

Movements in Stock Prices
Figure 15 - 6
Standard and Poors
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.
Macroeconomics, 4/e
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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:
$Q
$ D e t1
$ D e t2

e
(1 i1t ) (1 i1t ) (1 i 1t1 )
In real terms,
D e t1
D e t2
(1 r1t ) (1 r1t ) (1 r
1t1
Macroeconomics, 4/e
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Expectations
Stock Prices as Present Values
D e t1
D e t2
(1 r1t ) (1 r1t ) (1 r
1t1
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.
Macroeconomics, 4/e
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Expectations
The Stock Market

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.
Macroeconomics, 4/e
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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.
Macroeconomics, 4/e
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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 Feds
behavior.
Macroeconomics, 4/e
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Expectations
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.
Macroeconomics, 4/e
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Expectations
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.
Macroeconomics, 4/e
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Expectations
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.
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
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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.
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
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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
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
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CHAPTER 15

2006 Prentice Hall Business Publishing

Chapter 15: Financial Markets and

Bonds differ in two basic dimensions:

2006 Prentice Hall Business Publishing

Chapter 15: Financial Markets and

The yield curve, which

The relation between maturity and yield is called

2006 Prentice Hall Business Publishing

Chapter 15: Financial Markets and

Government bonds are bonds issued by

2006 Prentice Hall Business Publishing

Chapter 15: Financial Markets and

Bonds with high default risk are often called junk

2006 Prentice Hall Business Publishing

Chapter 15: Financial Markets and

The ratio of the coupon payments to the face

2006 Prentice Hall Business Publishing

Chapter 15: Financial Markets and

U.S. government bonds classified by maturity:

2006 Prentice Hall Business Publishing

Chapter 15: Financial Markets and

Bond Prices as Present Values

Consider two types of bonds:

Price of the two-year bond:

2006 Prentice Hall Business Publishing

Chapter 15: Financial Markets and

Arbitrage and Bond Prices

2006 Prentice Hall Business Publishing

Chapter 15: Financial Markets and

Arbitrage and Bond Prices

For every dollar you put in

If you hold a two-year bond, the price at which

2006 Prentice Hall Business Publishing

Chapter 15: Financial Markets and

Arbitrage and Bond Prices

The expectations hypothesis states that

Return per dollar

2006 Prentice Hall Business Publishing

Chapter 15: Financial Markets and

Arbitrage and Bond Prices

Arbitrage relations are relations that make the

The price of a one-year bond next year will

2006 Prentice Hall Business Publishing

Chapter 15: Financial Markets and

Arbitrage and Bond Prices

In words, the price of two-year bonds is the

2006 Prentice Hall Business Publishing

Chapter 15: Financial Markets and

From Bond Prices to Bond Yields

The yield to maturity on an n-year bond, or the

From here, we can solve for i2t.

2006 Prentice Hall Business Publishing

Chapter 15: Financial Markets and

From Bond Prices to Bond Yields

The yield to maturity on a two-year bond, is

In words, the two-year interest rate is the

2006 Prentice Hall Business Publishing

Chapter 15: Financial Markets and

Interpreting the Yield Curve

2006 Prentice Hall Business Publishing

Chapter 15: Financial Markets and

The Yield Curve