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A study material on financial markets and expectations, focusing on bond prices, stock markets, and arbitrage. It covers the role of expectations in financial markets, the concept of bonds and their yields, arbitrage conditions, and the relationship between bond prices and yields. The document also discusses the impact of financial crises on interest rates and yield curves.
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a)
Vocabulary b)
Arbitrage and bond prices)
g^
p
c) Stock market and stock prices d)
Bubbles and Fads
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1 Edition, © Pearson Education Limited 2010
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1 Edition, © Pearson Education Limited 2010
FINANCIAL MARKETS AND
EXPECTATIONS
EXPECTATIONS
-^
We introduce long-term bonds and stocks in our economyWe introduce long term bonds and stocks in our economy.
-^
How are bond prices and bond yields determined? How arethey affected by future expected interest rates?H
th
i ld
t^
l^
b^
t th
t d
-^
How can we use the
yi
eld curve to
learn about the expected
future interest rate?
-^
How are stock prices affected by expected future profits and interes rates?
-^
Do stock prices always reflect fundaments or may insteadreflect bubbles or fads?
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1 Edition, © Pearson Education Limited 2010
Figure 15.
UK yield curves: June 2007 and May 2009
The yield curve which was slightly downward
sloping in June 2007 was sharply
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1 Edition, © Pearson Education Limited 2010
The yield curve, which was slightly downward-sloping in June 2007, was sharplyupward-sloping in May 2009 Source
: Bank of England
t b
d^
b^
d^
i^
d b
t
overnment bonds
are bonds issued by government
agencies. Corporate bonds
are bonds issued by firms.
p^
y
Bond ratings
, issued by Standard and Poor’s, Moody’s,
t^
l^
t^
th i
d f
lt^
i k
etc., evaluate their default risk.The
risk premium
is the difference between the interest
rate paid on a given bond and the interest rate paid on the
p^
g^
p
bond with the highest rating.Bonds with high default risk are often called
junk bonds
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1 Edition, © Pearson Education Limited 2010
Th
t^
f th
i t
t^
t^
f^
b^
d i
The correct measure of the interest rate of a bond isneither the coupon rate nor the current yield, but its
yield
to maturity
, roughly the average interest rate paid by the
f
bond over its life.The
life of a bond
is the amount of time left until the bond
matures.
-^
Bonds typically promise to pay a sequence of fixednominal payments However other types of bonds callednominal 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
st^ , 1 Edition, © Pearson Education Limited 2010
b) Arbitrage and Bond Prices
Consider two types of bonds:
yp
A one-year bond—a bond that promises one payment of €100in one year. Intuitively, its price €P
1t^
has to be equal to the 1t
present value (the value today) of a payment of €100 nextyear:
-^
A two-year bond—a bond that promises one payment of €100in two years. Its price, €P
, should be equal to the present2t^
l value:
-^
Let’s now see how to derive this result formally using a
non
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1 Edition, © Pearson Education Limited 2010
Let s now see how to derive this result formally using a
non
arbitrage condition
-^
Suppose financial investors care only about
expected return
.
Arbitrage and Bond Prices
(a simplification: they are likely to care also about risk, which ishigher for a two-year bond, since the price at which you will sell itnext year is uncertain).Th
i^
ilib i
th
t^
b^
d^
t^
ff^
th
t d
-^
Then in equilibrium the two bonds must offer the
same expected
one-year
return
:
Expected returnper euro fromholding a two-year
Return per eurofrom holding aone-year bond for
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1 Edition, © Pearson Education Limited 2010
g^
y
bond for one year.
y one year.
Slide15.11^ •
Arbitrage
means that profit opportunities do not go unexploited.
Arbitrage and Bond Prices With risk neutrality, it implies that the expected returns on twoassets are equal (otherwise you could sell one, buy the other andexpect to make a profit).
Arbitrage implies that the price of a two-year bond today is thepresent value of the expected price of the bond next year:
-^
The price of the bond next year is expected to equal the finalThe price of the bond next year is expected to equal the finalpayment discounted by next year expected interest rate:
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1 Edition, © Pearson Education Limited 2010
From Bond Prices to Bond Yields
The
y
ield to maturity
on an
n-
year bond (the
n
-year interest
y^
y^
y^
y
rate
) is the constant annual interest rate that makes the bond price today equal to the present value of future payments of thebondbond.For a two-year bond, the two-year interest rate
i^ 2t
is the one that
satisfies:^ (Example: if today’s price
€
2t^
is
€
90, holding the bond for two
years yields an interest rate
i^ 2t
of 5,4% per year.)
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1 Edition, © Pearson Education Limited 2010
So
. But we also know that
From Bond Prices to Bond Yields Then which gives a relation between the two-year interest rate and one-yearinterest rates (current and expected next year).
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1 Edition, © Pearson Education Limited 2010
The slope of the Yield Curve
By looking at yields for bonds of different maturities, we can infer what financial markets expect short-term interest rateswill be in the future.
-^
An upward sloping yield curve means that long-term interestrates are higher than short-term interest rates. Financialmarkets expect short-term rates to be higher in the futuremarkets 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 l
rates are lower than short-term interest rates. Financialmarkets expect short-term rates to be lower in the future.
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1 Edition, © Pearson Education Limited 2010
-^
i^
i^
i
e 1
1
2
1
2 ^
e
The Yield curve
-^
i^
i^
i
t^
t^
t
1
1
2
1
2
^
1 1
2
t
t^
t
-^
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1 Edition, © Pearson Education Limited 2010
June 2007 (UK)June 2007 (UK) Financial crisis from US
t d t
d
expected to spread overthe world
→
Expectations
of recession
→
Expected
IS shift to the left
→
Expected decrease in theinterest rate
→
Yield curve
slightly downward sloping
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1 Edition, © Pearson Education Limited 2010
Slide15.20^ From June 2007 to May 2009
The Yield curve
y
was stronger than had been
t d Th
IS
hift d
expected. The
IS
curve shifted
much more to the left, to
IS’’.
g
early 2009 to a policy ofmonetary expansion, leadingto a downward shift in the
LM
to a downward shift in the
LM
curve, which made the interestrate even lower.
Blanchard, Amighini and Giavazzi,
Macroeconomics: A European Perspective
st^ , 1 Edition, © Pearson Education Limited 2010
