© 2003 prentice hall business publishingmacroeconomics, 3/eolivier blanchard prepared by: fernando...

© 2003 Prentice Hall Business Publishing© 2003 Prentice Hall Business Publishing Macroeconomics, 3/eMacroeconomics, 3/e Olivier BlanchardOlivier Blanchard

Prepared by:Prepared by:

Fernando Quijano and Yvonn Fernando Quijano and Yvonn QuijanoQuijano

1515C H A P T E RC H A P T E R

Financial MarketsFinancial Marketsand Expectationsand Expectations

© 2003 Prentice Hall Business Publishing© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Macroeconomics, 3/e Olivier BlanchardOlivier Blanchard

Bond PricesBond Pricesand Bond Yieldsand Bond Yields

15-1

Bonds differ in two basic dimensions:Bonds differ in two basic dimensions:1.1. Default riskDefault risk, the risk that the issuer of the bond , the risk that the issuer of the bond

will not pay back the full amount promised by the will not pay back the full amount promised by the bond.bond.

2.2. MaturityMaturity, the length of time over which the bond , the length of time over which the bond promises to make payments to the holder of the promises to make payments to the holder of the bond.bond.

Bonds of different maturities each have a Bonds of different maturities each have a price and an associated interest rate called price and an associated interest rate called the the yield to maturityyield to maturity, or simply the yield., or simply the yield.


Bond PricesBond Pricesand Bond Yieldsand Bond Yields

U.S. Yield Curves: U.S. Yield Curves: November 1, 2000 November 1, 2000 and June 1, 2001and 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 The relation between maturity and yield is called the yield curveyield curve, or the , or the term structure of interest rates.term structure of interest rates.


The Vocabulary of Bond MarketsThe Vocabulary of Bond Markets

Government bondsGovernment bonds are bonds issued by are bonds issued by government agencies.government agencies.

Corporate bondsCorporate bonds are bonds issued by firms. are bonds issued by firms. Bond ratingsBond ratings are issued by Standard and are issued by Standard and

Poor’s Corporation and Moody’s Investors Poor’s Corporation and Moody’s Investors Service.Service.

The The risk premiumrisk premium is the difference between is the difference between the interest rate paid on a given bond and the the interest rate paid on a given bond and the interest rate paid on the bond with the highest interest rate paid on the bond with the highest rating.rating.



Bonds with high default risk are often called Bonds with high default risk are often called junk bondsjunk bonds..

Bonds that promise a single payment at Bonds that promise a single payment at maturity are called maturity are called discount bondsdiscount bonds. The . The single payment is called the single payment is called the face valueface value of the of the bond.bond.

Bonds that promise multiple payments before Bonds that promise multiple payments before maturity and one payment at maturity are maturity and one payment at maturity are called called coupon bondscoupon bonds. The payments are . The payments are called called coupon paymentscoupon payments..



The ratio of the coupon payments to the face The ratio of the coupon payments to the face value of the bond is called the value of the bond is called the coupon ratecoupon rate..

The The coupon yieldcoupon yield is the ratio of the coupon is the ratio of the coupon payment to the price of the bond.payment to the price of the bond.

The The life of a bondlife of a bond is the amount of time left is the amount of time left until the bond matures.until the bond matures.



U.S. government bonds classified by maturity:U.S. government bonds classified by maturity: Treasury bills, or T-billsTreasury bills, or T-bills: Up to one year.: Up to one year. Treasury notesTreasury notes: One to ten years.: One to ten years. Treasury bondsTreasury bonds: Ten years or more.: Ten years or more.

Bonds typically promise to pay a sequence of Bonds typically promise to pay a sequence of fixed nominal payments. However, other fixed nominal payments. However, other types of bonds, called types of bonds, called indexed bondsindexed bonds, , promise payments adjusted for inflation rather promise payments adjusted for inflation rather than fixed nominal payments.than fixed nominal payments.


Bond Prices as Present ValuesBond Prices as Present Values

Consider two types of bonds:Consider two types of bonds: A one-year bond—a bond that promises one A one-year bond—a bond that promises one

payment of $100 in one year.payment of $100 in one year. A two-year bond—a bond that promises one A two-year bond—a bond that promises one

payment of $100 in two years. payment of $100 in two years.

Price of the one-year Price of the one-year bond:bond:

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

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Arbitrage and Bond PricesArbitrage and Bond Prices

Returns from Holding Returns from Holding One-Year and Two-Year One-Year and Two-Year Bonds for One YearBonds for One Year



If you hold a two-year bond, the price at which If you hold a two-year bond, the price at which you will sell it next year is uncertain—risky.you will sell it next year is uncertain—risky.

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 $Pe

1t+1 dollars next year.



The The expectations hypothesisexpectations hypothesis states that investors states that investors care only about expected return.care only about expected return.

If two bonds offer the same expected one-year return, If two bonds offer the same expected one-year return, then:then:

Expected return per dollar from holding a two-year bond for one year.

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Return per dollar from holding a one-year bond for one year.



ArbitrageArbitrage relations are relations that make the relations are relations that make the expected returns on two assets equal.expected returns on two assets equal.

Arbitrage implies that the price of a two-year Arbitrage implies that the price of a two-year bond today is the present value of the expected bond today is the present value of the expected price of the bond next year.price of the bond next year.

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The price of a one-year bond next year will The price of a one-year bond next year will depend on the one-year rate next year.depend on the one-year rate next year.

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GivenGiven andand , then:, then:

In words, the price of two-year bonds is the present In words, the price of two-year bonds is the present value of the payment in two years—discounted using value of the payment in two years—discounted using current and next year’s expected one-year interest rate.current and next year’s expected one-year interest rate.

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From Bond Prices to Bond YieldsFrom Bond Prices to Bond Yields

The The yield to maturityyield to maturity on an n-year bond, or the on an n-year bond, or the n-n-year interest rateyear interest rate, is the constant annual interest rate , is the constant annual interest rate that makes the bond price today equal to the present that makes the bond price today equal to the present value of future payments of the bond.value of future payments of the bond.

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, then:, then:

therefore:therefore: $100

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From here, we can solve for From here, we can solve for ii2t2t..


From Bond Prices to Bond YieldsFrom Bond Prices to Bond Yields

The The yield to maturityyield to maturity on a two-year bond, is closely on a two-year bond, is closely approximated by:approximated by:

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In words, the two-year interest rate is the average of In words, the two-year interest rate is the average of the current one-year interest rate and next year’s the current one-year interest rate and next year’s expected one-year interest rate.expected one-year interest rate.

Long-term interest rates reflect current and future Long-term interest rates reflect current and future expected short-term interest rates.expected short-term interest rates.


Interpreting the Yield CurveInterpreting the Yield Curve

An upward sloping yield curve means that An upward sloping yield curve means that long-term interest rates are higher than short-long-term interest rates are higher than short-term interest rates. Financial markets expect term interest rates. Financial markets expect short-term rates to be higher in the future.short-term rates to be higher in the future.

A downward sloping yield curve means that A downward sloping yield curve means that long-term interest rates are lower than short-long-term interest rates are lower than short-term interest rates. Financial markets expect term interest rates. Financial markets expect short-term rates to be lower in the future.short-term rates to be lower in the future.


The Yield CurveThe Yield Curveand Economic Activityand Economic Activity

The U.S. economy as of The U.S. economy as of November 2000November 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.



The U.S. Economy from The U.S. Economy from November 2000 to June November 2000 to June 20012001

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.



The Expected Path of The Expected Path of the U.S. Economy as of the U.S. Economy as of June 2001June 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 The anticipation of higher short-term interest rates was the reason why long-term interest rates remained high, why the yield reason why long-term interest rates remained high, why the yield curve was upward sloping in June 2001.curve was upward sloping in June 2001.


The Stock Market and Movements The Stock Market and Movements in Stock Pricesin Stock Prices

15-2

Firms raise funds in two ways:Firms raise funds in two ways:1.1. Through Through debt financedebt finance—bonds —bonds

and loans; andand loans; and

2.2. Through Through equity financeequity finance, , through issues of through issues of stocksstocks—or —or sharesshares..

Bonds pay predetermined Bonds pay predetermined amounts; stocks pay amounts; stocks pay dividendsdividends from the firm’s from the firm’s profits.profits.


The Stock Market andThe Stock Market andMovements in Stock PricesMovements in Stock Prices

Standard and Poor’s Standard and Poor’s Stock Price Index in Stock Price Index in Nominal and Real Nominal and Real Terms, 1960-2000Terms, 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.


Stock Prices as Present ValuesStock Prices as Present Values

The price of a stock must equal the present The price of a stock must equal the present value of future expected dividends, or the value of future expected dividends, or the present value of the dividend next year, of two present value of the dividend next year, of two years from now, and so on:years from now, and so on:

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Stock Prices as Present ValuesStock Prices as Present Values

This relation has two important implications:This relation has two important implications: Higher expected future real dividends lead to a Higher expected future real dividends lead to a

higher real stock price.higher real stock price. Higher current and expected future one-year real Higher current and expected future one-year real

interest rates lead to a lower real stock price.interest rates lead to a lower real stock price.

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The Stock MarketThe Stock Marketand Economic Activityand Economic Activity

Stock prices follow a Stock prices follow a random random walkwalk if each step they take is if each step they take is as likely to be up as it is to be as likely to be up as it is to be down. Their movements are down. Their movements are therefore unpredictable.therefore unpredictable.

Major movements in stock Major movements in stock prices cannot be predicted.prices cannot be predicted.


A Monetary ExpansionA Monetary Expansionand the Stock Marketand the Stock Market

An Expansionary An Expansionary Monetary Policy and the Monetary Policy and the Stock MarketStock 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.


An Increase in ConsumerAn Increase in ConsumerSpending and the Stock MarketSpending and the Stock Market

An Increase in An Increase in Consumption Spending Consumption Spending and the Stock Marketand 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.




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.




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.


Bubbles, Fads,Bubbles, Fads,and Stock Pricesand Stock Prices

15-3

Stock prices are not always equal to their Stock prices are not always equal to their fundamental valuefundamental value, or the present value of , or the present value of expected dividends.expected dividends.

Rational speculative bubblesRational speculative bubbles occur when occur when stock prices increase just because investors stock prices increase just because investors expected them to.expected them to.

Deviations of stock prices from their Deviations of stock prices from their fundamental value are called fundamental value are called fadsfads..


Key TermsKey Terms

default risk,default risk, maturity,maturity, yield curve,yield curve, term structure of interest rates,term structure of interest rates, government bonds,government bonds, corporate bonds,corporate bonds, bond ratings,bond ratings, risk premium,risk premium, junk bonds,junk bonds, discount bonds,discount bonds, face value,face value, coupon bonds,coupon bonds, coupon payments,coupon payments,

coupon rate,coupon rate, current yield,current yield, life (of a bond),life (of a bond), Treasury bills, or T-bills,Treasury bills, or T-bills, Treasury notes,Treasury notes, Treasury bonds,Treasury bonds, indexed bonds,indexed bonds, expectations hypothesis,expectations hypothesis, arbitrage,arbitrage, yield to maturity, or yield to maturity, or nn-year -year

interest rate,interest rate, soft landing,soft landing, debt finance,debt finance,

continued…continued…


Key TermsKey Terms

equity finance,equity finance, shares, or stocks,shares, or stocks, dividends,dividends, random walk,random walk,

Fed accommodation,Fed accommodation, fundamental value,fundamental value, rational speculative bubbles,rational speculative bubbles, fads,fads,

© 2003 prentice hall business publishingmacroeconomics, 3/eolivier blanchard prepared by: fernando...

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