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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/eOlivier Blanchard Prepared by: Fernando Quijano and Yvonn Quijano 15 C H A P T E R Financial Markets and Expectations

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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. Bonds of different maturities each have a price and an associated interest rate called the yield to maturity, or simply the yield.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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:

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Arbitrage and Bond Prices Returns from Holding One-Year and Two-Year Bonds for One Year

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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: Expected return per dollar from holding a two-year bond for one year. Return per dollar from holding a one-year bond for one year.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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 one-year bond next year will depend on the one-year rate next year.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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, why the yield curve was upward sloping in June 2001.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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,

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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. Major movements in stock prices cannot be predicted.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard 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.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Bubbles, Fads, and Stock Prices 15-3 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.

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Key Terms default risk, default risk, default risk, maturity, maturity, yield curve, yield curve, yield curve, term structure of interest rates, term structure of interest rates, term structure of interest rates, government bonds, government bonds, government bonds, corporate bonds, corporate bonds, corporate bonds, bond ratings, bond ratings, bond ratings, risk premium, risk premium, risk premium, junk bonds, junk bonds, junk bonds, discount bonds, discount bonds, discount bonds, face value, face value, face value, coupon bonds, coupon bonds, coupon bonds, coupon payments, coupon payments, coupon payments, coupon rate, coupon rate, coupon rate, current yield, current yield, current yield, life (of a bond), life (of a bond), life (of a bond), Treasury bills, or T-bills, Treasury bills, or T-bills, Treasury bills, or T-bills, Treasury notes, Treasury notes, Treasury notes, Treasury bonds, Treasury bonds, Treasury bonds, indexed bonds, indexed bonds, indexed bonds, expectations hypothesis, expectations hypothesis, expectations hypothesis, arbitrage, arbitrage, yield to maturity, or n-year interest rate, yield to maturity, or n-year interest rate, yield to maturity, or n-year interest rate, soft landing, soft landing, soft landing, debt finance, debt finance, debt finance,continued…

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© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Key Terms equity finance, equity finance, equity finance, shares, or stocks, shares, or stocks, shares, or stocks, dividends, dividends, random walk, random walk, random walk, Fed accommodation, Fed accommodation, Fed accommodation, fundamental value, fundamental value, fundamental value, rational speculative bubbles, rational speculative bubbles, rational speculative bubbles, fads, fads,

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