Financial Markets and ExpectationsHow Do Expectations Affect Asset Prices?Slide 3VocabularyBond Prices and Bond YieldsSlide 6The Vocabulary of Bond MarketsSlide 8Slide 9Slide 10Bond Prices as Present ValuesSlide 12Slide 13Arbitrage and Bond PricesSlide 15Slide 16Slide 17Slide 18Slide 19ArbitrageFrom Bond Prices to Bond YieldsSlide 22Interpreting the Yield CurveSlide 24The Yield Curve and Economic ActivitySlide 26Slide 27Slide 28The Stock Market and Movements in Stock PricesSlide 30Stock Prices as Present ValuesSlide 32Slide 33The Stock Market and Economic ActivityA Monetary Expansion and the Stock MarketSlide 36An Increase in Consumer Spending and the Stock MarketSlide 38Slide 39Slide 40Bubbles, Fads, and Stock PricesPrepared by:Prepared by:Fernando Quijano and Yvonn QuijanoFernando Quijano and Yvonn Quijano1515C H A P T E RC H A P T E RFinancial Marketsand ExpectationsFinancial Marketsand ExpectationsHow Do Expectations Affect Asset Prices? How Do Expectations Affect Asset Prices? •An asset is expected to provide a stream of future payments to the owner.•Putting aside speculative bubbles, the value of an asset (its price) at any moment in time is the expected present discounted value of the stream of future payments.How Do Expectations Affect Asset Prices? How Do Expectations Affect Asset Prices? •Putting aside risk, the expected real return on all assets should be the same; otherwise, investors would be willing to hold only the asset with the highest expected return.•Since asset prices depend on expectations about the future, they are greatly affected by new information that changes these expectations. Likewise, the more unexpected an economic event—e.g., a monetary policy decision—the greater its effect on asset prices.VocabularyVocabulary•This chapter introduces a large amount of financial vocabulary.•To really benefit from this chapter (and it will be very useful knowledge), you should try to memorize the Key Terms at the end of the chapter and their meanings.Bond Pricesand Bond YieldsBond Pricesand Bond Yields15-1•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.1. Also called “term” (e.g., a long-term bond is one that matures many years after issuance).Bond Pricesand Bond YieldsBond Pricesand Bond Yields•Bonds of different maturities each have a price…and an associated interest rate, called the yield to maturity, or simply the yield.–If we arrange the yields of different maturities, we can get a “yield curve.”The Vocabulary of Bond MarketsThe 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.The Vocabulary of Bond MarketsThe 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.The Vocabulary of Bond MarketsThe 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.The Vocabulary of Bond MarketsThe 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.Bond Prices as Present ValuesBond 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 Price of the two-year bond:bond:$$ 1 0 0Pitt11$$ 1 0 0( ) ( )Pi ittet21 11 1 Bond Prices as Present ValuesBond Prices as Present Values•One-year bonds: For every dollar you put in, you will get (1+ i1t) dollars next year.Bond Prices as Present ValuesBond Prices as Present Values•Two-year bonds: For every dollar you put in, you get a quantity $1/$P2t of two-year bonds today.A year later, your bond will have become a one-year bond, of price $Pe1t+1.If you sold the bond, you’d get $Pe1t+1 dollars times the quantity of two-year bonds, $1/$P2tSo you can expect to get $Pe1t+1/$P2t next year.Arbitrage and Bond PricesArbitrage 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+ 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.Returns from Holding One-Year and Two-Year Bonds for One YearArbitrage and Bond PricesArbitrage and Bond Prices•The expectations hypothesis assumes that investors care only about expected return.–Ignores risk•If two bonds offer the same expected one-year return, then:111 12 iPPtett $$Return per dollar from holding a one-year bond for one year.Expected return per dollar from holding a two-year bond for one year.Arbitrage and Bond PricesArbitrage and Bond Prices•Arbitrage relations are relations that make the expected returns on two assets equal.•Arbitrage implies that the price of a two-year bond today is the present value of the expected price of the bond next year.–The price of a two-year bond is the expected present value of a one-year bond that you get next year.$$PPitett21 111Arbitrage and Bond PricesArbitrage and Bond Prices•Arbitrage relations are relations that make the expected returns on two assets equal.The price of a one-year