Asset Prices and Interest rates Flashcards
Future value of dollar (definition)
- value of a dollar today in terms of dollars at some future time
Future Value (formula)
1 dollar today = dollar . (1 + i)n
- “n” stand for years
- “i” stand for interest rate
Present value of dollar (definition)
- value of a future dollar in terms of today’s dollars
present value (PV) (formula)
1 dollar in “n” years = 1 dollar / (1 + i)n
- “n” stand for numbers of year
- “i” stand for interest rate
Classical theory of asset prices
- the price of an asset equals the present value of expected income from the asset
asset price = present value of expected asset income
what is a dividend ?
- payment from a firm to its stockholders
what is Rational expectations ? (theory)
- Theory that people’s expectations of future variables are the best possible forecasts based on all available information
Safe interest rate (isafe):
- interest rate that savers can receive for sure; also known as risk-free rate
what is Risk premium ? (symbol of risk premium)
- Payment on an asset that compensates the owner for taking on risk
what is Risk-adjusted interest rate ?
- sum of the risk-free interest rate and the risk premium on an asset,
(isafe + w)
- “W”using as Risk premium
- “isafe” stand for safe interest rate
what is Gordon growth model ? (theory) (formula)
- Theory in which a stock price “P” is determined by an initial expected dividend, the expected growth rate of dividends, and the risk-adjusted interest rate
P = D1 / ( i – g )
- “D1” stand for initial expected dividend
- “g” stand for the expected grow rate of dividends
- “i” stand for the risk-adjusted interest rate
When the Fed raises interest rates, what effects the stock market show?
- Higher safe interest rate.
- Higher interest rates reduce spending by consumers and firms
- higher risk premiums (still in debate)
If the Fed raises interest rates, how the interest rate of economy’s safe is affected ? (stock effects)
- A higher safe rate reduces the present value of dividends received by stockholders, which decreases stock prices.
If the Fed raises interest rates, how the risk premiums are affected ?
- A slower economy not only reduces expected earnings but also raises uncertainty
- it is hard to predict how badly companies will be hurt by the slowdown
- Greater uncertainty means higher risk premiums
- which raise risk-adjusted interest rates and decrease present values and stock prices.
when the change of interest rate of the Fed is more effective ?
- Only when they are unexpected.
Which assets prices are most volatile ?
- Long-Term Bond Prices: A change in interest rates has a larger effect on prices of long-term bonds than on prices of short-term bonds.
- Stock Prices: Prices for stocks are more volatile than prices for bonds, even long-term bonds
why the Long-Term Bond Prices is more volatile than the short-term bonds ?
- The short-term bonds provide income only in the near future, whereas most payments on long-term bonds come later
- The present value of payments is affected more strongly by the interest rate if the payments come later.
two main reasons by which the Stock prices fluctuate more ?
- Stocks yield income far into the future. (like long-term bonds)
- Changes in expected earnings add to the fluctuations caused by changes in interest rates
* The news about firms and the economy causes changes in expected earnings and dividends and thus in stock prices
what is Asset-price bubble ?
- The rapid rise in asset prices that is not justified by changes in interest rates or expected asset income
what is Price-earnings ratio (P/E ratio)?
- A company’s stock price divided by earnings per share over the recent past
Meaning of Asset-price crash :
- A large and rapid fall in asset prices
Meaning of “Margin requirements”: (crash prevention)
- Limits on the use of credit to purchase stocks - they have been around 50 percent of a person’ money.
Meaning of “Circuit breaker” : (crash prevention)
- The requirement that a securities exchange shut down temporarily if prices drop by a specified percentage
Meaning of “Yield to maturity” :
- The interest rate that makes the present value of payments from a bond equal to its price
Meaning of Capital gain:
- The increase in an asset holder’s wealth from a change in the asset’s price
Meaning of Capital loss:
- The decrease in an asset holder’s wealth from a change in the asset’s price
what is a “return” in stock and bonds ?
- The total earnings from a security;
- the capital gain or loss plus any direct payment (coupon payment or dividend); return
- (P1 –P0) + X
what is Rate of return?
- It is the return on a security as a percentage of its initial price;
rate of return = (P1 – P0)/P0 + X/P0
Rate of return vs Yield to maturity
- Both variables tell us something about how much you earn by holding the bond, But they can behave quite differently.
- a decrease in a bond’s price can simultaneously cause:
1. increase in the yield to maturity (because a bond’s price and its yield are inversely related)
2. negative rate of return (because bondholders suffer capital losses).
If you are thinking of buying a bond, which variable should you care about? (Rate of return or Yield to maturity
- The answer depends on how long you are likely to hold the bond :
1. If you hold the bond until it matures, the yield to maturity tells what interest rate you receive, Fluctuations in the bond’s price are irrelevant if you never sell the bond.
2. if you sell the bond after a year, you will receive the rate of return for the year. The yield to maturity does not matter if you don’t hold the bond to maturity.
what is Nominal interest rate ( i )?
- It is a interest rate offered by a bank account or bond
what is Real interest rate (r)? (formula)
- The nominal interest rate minus the inflation rate;
r = i - pi
- “r” stand for real rate
- “i” stand for nominal interest rate
- “pi” stand for inflation rate
what is Ex ante real interest rate (rex ante) ?
- Nominal interest rate minus expected inflation over the loan period;
rex ante = i - (pi)*expected
- r<strong>ex ante</strong> stand for real interest rate previous
- “i” stand for nominal interest rate
- “pi* “ stand for expected inflation
what is Ex post real interest rate (rex post) ?
- The nominal interest rate minus actual inflation over the loan period;
rex post = i - pi(actual)
- “rex post“ stand for actual real interest rate
- “i” stand for nominal interest rate
- “pi “ stand for inflation
what is Inflation-indexed bond?
- It is a bond that promises a fixed real interest rate;
- the nominal rate is adjusted for inflation over the life of the bond
bond price (formula)
C/(1 + i) + C /(1 + i)2 + … + C /(1 + i)t-1 + (C + F) /(1 + i)t
- “C” stand for annual coupon payment
- “i” stand for interest rate
- “t” stand for maturity (time)
- “F” stand for face value
stock price (formula)
D1 /(1 + i) + D2 /(1 + i) + D3 /(1 + i) + …
- “D” stand for dividend
- “i” stand for interest rate
The Classical Theory of Asset Prices (graph)
The Fed and the Stock Market (graph)
An Asset’s Rate of Return (formula)
Rate of return = return / P0 = (P1 - P0)/P0 + X/P0
- “P0“ stand for the initial price of the security
- “P1“ stand for the price after you hold it for a year
- “X” represents a direct payment, (X can be a coupon payment, C, or a dividend, D.)
