Financial Markets and Expectations: Bond Prices, Stock Markets, and Arbitrage, Apuntes de Economía

¡Descarga Financial Markets and Expectations: Bond Prices, Stock Markets, and Arbitrage y más Apuntes en PDF de Economía solo en Docsity! I.2 FINANCIAL MARKETS AND EXPECTATIONS a) Vocabulary b) Arbitrage and bond prices c) Stock market and stock prices d) Bubbles and Fads Ch. 15 in Blanchard-Amighini-Giavazzi Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 FINANCIAL MARKETS AND EXPECTATIONS Slide 15.2 Expectations also play an essential role in financial markets: • We introduce long-term bonds and stocks in our economy . • How are bond prices and bond yields determined? How are they affected by future expected interest rates? H th i ld t l b t th t d• ow can we use e y e curve o earn a ou e expec e future interest rate? • How are stock prices affected by expected future profits and interes rates? • Do stock prices always reflect fundaments or may instead reflect bubbles or fads? Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 Slide 15.5 G t b d b d i d b t• overnmen on s are on s ssue y governmen agencies. Corporate bonds are bonds issued by firms. • Bond ratings, issued by Standard and Poor’s, Moody’s, t l t th i d f lt i ke c., eva ua e e r e au r s . 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. Bonds with high default risk are often called junk bonds. Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 Slide 15.6 • Bonds that promise a single payment at maturity are called discount bonds. The face value (or par value) of the bond is the amount paid to the bond holder at the maturity date. • Bonds that promise multiple payments before maturity and t t t it ll d b done paymen a ma ur y are ca e coupon on s. The payments are called coupon payments. 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 Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 . Slide 15.7 Th t f th i t t t f b d i• e correc measure o e n eres ra e o a on s neither the coupon rate nor the current yield, but its yield to maturity, roughly the average interest rate paid by the fbond over its li e. The life of a bond is the amount of time left until the bond matures. • 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. Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 Slide 15.10 • Suppose financial investors care only about expected return. Arbitrage and Bond Prices (a simplification: they are likely to care also about risk, which is higher for a two-year bond, since the price at which you will sell it next year is uncertain). Th i ilib i th t b d t ff th t d• en n equ r um e wo on s mus o er e same expec e one-year return: Expected return per euro from holding a two-year Return per euro from holding a one-year bond for Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 bond for one year.one year. Slide 15.11 • Arbitrage means that profit opportunities do not go unexploited. Arbitrage and Bond Prices With risk neutrality, it implies that the expected returns on two assets are equal (otherwise you could sell one, buy the other and expect to make a profit). • 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 the bond next year is expected to equal the final payment discounted by next year expected interest rate: Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 Slide 15.12 • Hence (substituting the second into the first condition) Arbitrage and Bond Prices arbitrage implies that the price of the two-year bond is the present value of the final payment discounted using current and next year expected one year interest rates: - Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 Slide 15.15 An approximation to this relation is given by: From Bond Prices to Bond Yields 1 12 1 1 ( ) 2 e tt ti i i   In words, the two-year interest rate is (approximately) 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. Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 The slope of the Yield Curve Slide 15.16 • By looking at yields for bonds of different maturities, we can infer what financial markets expect short-term interest rates will be in the future. • 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 t l th h t t i t t t Fi i lra es are ower an s or - erm n eres ra es. nanc a markets expect short-term rates to be lower in the future. Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 Slide 15.17 • From you get i i ie1 1 2 12  1 ( )ei i i  The Yield curve to find out what financial markets expect the 1-year interest t t t1 12 12 tt t  rate to be 1 year from now. E l (UK Fi 15 1) O 31 M 2009 th• xamp e - g. . . n ay , e one-year interest rate was 0,66%, the two-year interest rate 1,35%: thus markets expected the one-year interest rate one-year later to be 2,04% (much higher). Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 Slide 15.20 From June 2007 to May 2009 The Yield curve • The adverse shift in spending was stronger than had been t d Th IS hift dexpec e . e curve s e much more to the left, to IS’’. • The Bank of England shifted in early 2009 to a policy of monetary expansion, leading to a downward shift in the LM curve, which made the interest rate even lower. Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 Slide 15.21 May 2009 The Yield curve • Markets expected a recovery from the recession - expansionary fiscal policy, a pickup in spending - a shift of the IS curve to the right. • They also expected that, with output recovering, the central bank would be shifting back to a tighter monetary policy (LM up). • Hence short-term interest rates were expected to increase, so long- Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 term interest rates were higher (upward sloping yield curve) c) The Stock Market and Stock Prices Slide 15.22 Firms raise funds in two ways: Th h d bt b d d l• roug e — on s an oans; • Through equity — issues of stocks (or shares). Instead of paying predetermined amounts as bonds do , , stocks pay dividends in an amount decided by the firm (usually related to profits). Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 Arbitrage and Stock Prices Slide 15.25 The present value relation can be derived from arbitrage conditions (b t t k d b d )e ween s oc s an on s : • for every euro you put in one-year bonds, next year you will get (1+ i1t) • every euro you put in stocks buys you €1/ €Qt stocks from each of which , you expect to get next year €Det+1+€Qet+1 (the expected dividend and price); therefore, for every euro you put in stocks, you expect to get (€De +€Qe ) / €Qt+1 t+1 t. If financial investors care only about expected returns, equilibrium requires that the expected return from holding stocks for one year be the same as the rate of return on one-year bonds: (€Det+1+€Qet+1) / €Qt = (1+ i1t); that can be read as Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 €Qt = (€Det+1+€Qet+1) / (1+ i1t) €Qt = (€Det+1+€Qet+1) / (1+ i1t) Slide 15.26 The price of the stock today must be equal to the present value of the Stock prices expected dividend and stock price next year. What determines €Qet+1? The same condition one period ahead: €Qe = (€De +€Qe ) / (1+ ie )t+1 t+2 t+2 1t+1 Substituting we have €Qt = €Det+1 /(1+ i1t) + (€Det+2 +€Qet+2) /(1+ i1t)(1+ ie1t+1) then we can substitute €Qet+2 etc.. If future prices are expected not to explode, but to be bounded above by some finite value, as we increase the b f i d th t l f th t d fi l i illnum er o per o s e presen va ue o e expec e na pr ce w decrease, eventually going to zero (because the discount factor becomes larger and larger). Hence we end up with the present value relation: Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 €Qt = €Det+1 /(1+ i1t) + €Det+2 /(1+ i1t)(1+ ie1t+1) + … Movements in Stock Prices Slide 15.27 Stock prices show large movements (may go up or down by 20% or more within a year, or more than 2% in a day). But these movements are for the most part unpredictable. Why? If people expected a stock price to be 20% higher next year , there would be a very large demand for that stock (much more attractive than short-term bonds): its price would increase today until the expected returns of holding that stock or other assets were again equal. Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 Slide 15.30 An Increase in Consumer Spending Suppose there is an unexpected increase in consumption spending → IS shifts to the right → higher output and higher interest rate. What happens to the stock market? • a stronger economy (higher output) means higher profits and higher dividends for some time → positive effect on stock prices • but higher interest rates → negative effects on stock prices (dividends are discounted more heavily – bonds are relatively more attractive) Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 Slide 15.31 Which effect dominates? An Increase in Consumer Spending • 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 → stock prices go down. Reminder: the LM is flatter, the higher is the interest rate elasticity (and the lower the income elasticity) of money demand Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 . Slide 15.32 The answer also depends on how the An Increase in Consumer Spending market expects the central bank to react to the unexpectedly strong economic activity: • If the central bank is expected to increase money supply to avoid the increase in interest rates (to A’, e.g. starting from a recession) → stock prices go up. • If the central bank is expected to worry about inflation (e.g. with output at the natural level) hence to contract money supply (to A’’) → stock prices go down. Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 Slide 15.35 • Sept. 1998. Bad news on the economy, leading to an decrease in stock prices: ‘Nasdaq stocks plummeted as worries about the strength of the US economy and the profitability of US corporations prompted widespread selling’. • Aug. 2001. Bad news on the economy, leading to an increase in stock prices: ‘Investors shrugged off more gloomy economic news, and focused instead on th i h th t th t i f b th th d th t ke r ope a e wors s now over or o e economy an e s oc market. The optimism translated into another 2% gain for the Nasdaq Composite Index’. Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 Bubbles and Fads Slide 15.36 Do all movements in stock prices result from news about future dividends i t t t ?or n eres ra es US Oct 1929: -23% in 2 days; UK Oct 1987: -27% in a month, Oct 2008 and Jan 2009: -17%; Japan: almost tripling from ’85 to ’89, then losing most of the gain b ’92 cases lacking ne s important eno gh y – w u to cause such enormous movements. Stock prices may not always equal to their fundamental value (the t l f t d di id d )presen va ue o expec e v en s . • Mispricing can occur even when investors are rational and arbitrage holds → Rational speculative bubbles: stock prices increase just because investors expect them to. • Waves of excessive optimism (or pessimism) may also cause ‘irrational’ deviations called fads (e.g. a succession of price increases in the past Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 extrapolated to a belief that it will keep increasing). Slide 15.37 Imagine a stock of a company expected never to make profits and never to Bubbles and self-fulfilling expectations pay dividends: its fundamental value (present value of dividends) is zero. Might people be willing to buy it at a positive price? f fMaybe: i they expect the price to be higher in the uture. But the price next year will only be positive and higher than today if people expect an even higher price later in the future, and so on. From arbitrage, with zero expected dividends: €Qt = €Qet+1 / (1+ i1t). A positive price today is justified if €Qet+1 = (1+ i1t) €Qt, and that is justified by €Qet+2 = (1+ ie1t+1) €Qet+1, and so on: if the price is expected to be ever increasing in the future, its present value will not go to zero. So we can have a sequence of positive and increasing stock prices above Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010 the fundamental value, just based on self-fulfilling expectations – a bubble.