Financial markets, expectations and their relevance for monetary policy Flashcards
Discount factor
1 /1+it
The expected present discounted value of a sequence of future payments is
is the value today of this expected sequence of payments. Once the manager has computed the expected present discounted value of the sequence of profits, her problem becomes simpler.
The higher the interest it, the lower is
the present value of a payment in the future
Nominal
Present value = V_t = ∑ z_t+n / (1 + i_t)(1 + i_{e t+1})…(1 + i_{e t+n})
Discount rate
The rate at which you discount in this case the nominal interest i
Real
voir page 21: formule
Present value depends:
-positively on payment flows
-negatively on level of the interest rates
Important for the interest rate of a bond:
maturity, default risk (abstracted from for simplicity)
n-year maturity
Pnt = 100 (1+int )^n
Expectations hypothesis:
investors only care about the expected return
Price for the n-year bond equals…
the present value of the expected price of a one-year bond purchased in period n -1
yield curve
Une courbe de rendement est une ligne qui représente les rendements ou les taux d’intérêt d’obligations ayant la même qualité de crédit mais des dates d’échéance différentes
–> Relation between bond and interest rate
The yield curve is the relation between the yield of bonds and their maturity.
Upward sloping yield curve
financial markets expect higher short-term interest rates
Downward sloping yield curve
financial markets expect lower short-term interest rates (indicator for recessions)
▶ But: long-term interest rates also include liquidity- and risk-premium
⇒ Changes in these premia over time constrain what one can learn from the yield curve about interest-rate expectations
Forward Guidance Influence the yield curve by…
guiding interest-rate expectations
Quantitative easing as unorthodox monetary-policy option
▶ Zero lower bound for short-term interest rate
▶ Reduce interest of long-term bonds (given imperfect arbitrage
Quantitative easing
a form of monetary policy in which a central bank, like the U.S. Federal Reserve, purchases securities in the open market to reduce interest rates and increase the money supply.
Quantitative easing in the IS-LM Model
▶ ”Perfect trap”
- Liquidity trap
- Fiscal policy not effective or not (politically) feasible
▶ Role for quantitative easing as unorthodox monetary policy option
Fundamental value Q of a stock is
the present value of future dividend payments D
real interest includes
risk premium: is the investment return an asset is expected to yield in excess of the risk-free rate of return
Stock price
- decreases if interest rates are higher (today and in the future)
- decreases if the risk premium is higher
Efficient-market hypothesis
stock prices cannot be predicted systematically (random walk)
Rational speculative bubbles
based on expectations of price increases
Possible that things (possibly without much fundamental value such as tulip bulbs) realize …
big capital gains through price increases
expansionary monetary policy and stock prices: Effect on stock prices
increase if monetary policy not anticipated
- unchanged if monetary policy anticipated
The Net Present Value (NPV) of an asset
is the sum of all future cash flows discounted to their present value
Decrease of cash flow impact on NPV ?
The present value of that cash flow will be lower. So the NPV will decrease
zt
payement flow
zte
expected payement flow of that year
How does the present value of future payments change with interest rates?
Present value decreases as interest rates increase.
Arbitrage
is a financial strategy where an investor takes advantage of price differences of the same asset in different markets
For example, if stock is priced at $100 on one exchange and $102 on another, an arbitrageur could buy the stock for $100 and immediately sell it for $102, making a $2 profit per share.
What is the role of arbitrage in determining the yield curve?
Arbitrage ensures that the price of a bond equals the expected price of future one-year bonds.
What is the expectations hypothesis regarding bond prices?
Bond prices reflect the expected return over time, equal to the present value of future bonds.
How does an upward-sloping yield curve affect interest rate expectations?
It suggests that financial markets expect higher short-term interest rates in the future
How can monetary policy influence the yield curve?
Through forward guidance and quantitative easing, affecting interest-rate expectations.
What is the fundamental value of a stock?
The present value of expected future dividend payments, adjusted for real interest and risk.
How does the risk premium affect stock prices?
The present value of expected future dividend payments, adjusted for real interest and risk.
How does the risk premium affect stock prices?
Higher risk premiums lead to lower stock prices, while lower premiums increase stock prices.
What is the efficient-market hypothesis regarding stock prices?
Stock prices cannot be systematically predicted as they follow a random walk.
What is a speculative bubble in financial markets?
A market situation where asset prices rise far above their fundamental value due to speculation.
How does expansionary monetary policy affect stock prices?
Stock prices increase if the monetary policy is not anticipated, but remain unchanged if anticipated.
What is the equity premium?
is the extra return that investors require for holding stocks, which are considered riskier, as compared to risk-free assets like government bonds.
Which formula gives the real stock price as the present value of real expected dividends, discounted by both the real interest rates and the equity premium, which captures the risk associated with investing in stocks over risk-free assets ?
Qt = Dte / (1 + r1t + x) + Dte/ (1 + rt1 + x) (1+ rt2 + x) …
In this formula what is x, rt and ret ?
Qt = Dte / (1 + r1t + x) + Dte/ (1 + rt1 + x) (1+ rte2 + x) …
x represents the equity premium
rt is the real interest rate at time t.
rte is is the expected future real interest rate at time t + 1
–> the higher the expected dividend De , the higher the stock price Q .
Temporary Change in r1t
the stock price increases slightly due to the lower short-term rate, but the increase is not large since the change is temporary.
Permanent Change in
r1t
stock prices will rise sharply when the decrease in interest rates is expected to be permanent.
Permanent Change in r1t with Decreased Expected Future Output and Dividends
Stock prices may increase less or even fall if a permanent rate cut is accompanied by lower expected future output and dividends.
If the price-rent ratio is increasing, it is more likely due…
to lower interest rates
Higher interest rates increase the discount rate used to calculate the present value of future rents, which would lead to…
a decrease in house prices relative to rent
Price-RentRatio
PropertyPurchasePrice / Annual rent
If housing is perceived as a riskier investment, the price-rent ratio will…
likely decrease. The reason is that a higher perceived risk leads to a higher risk premium (x) in the discount rate. This increases the rate at which future rents are discounted, reducing the present value of those rents and, therefore, reducing house prices.
The yield curve is horizontal
when the interest rate remain constant forever
BondPrice
F1,t+1 / 1 + i1t
expected return on stock calculation
Det+1 + Qet+1- Qt/ Qt
and i 1,t +x
Long run : growth
- determinants of cross-country differences
- determinants of income differences across time
(growth miracles)
Business cycle : Short to medium run
- determinants of macroeconomic fluctuations (in quantities and prices)
- supply-side versus demand-side explanations
Real
Present value = Vt / Pt = ∑ z_t+n / (1 + i_t)(1 + i_{e t+1})…(1 + i_{e t+n})
Present value depends on ?
positively on payment flows
negatively on level of the interest rates
Important for the interest rate of a bond?
- maturity
- default risk (liquity on the market)
Default risk
Situation où le marché concurrentiel ne suffit pas à atteindre l’optimum collectif, soit parce que les biens ou services ne peuvent être fournis de façon marchande, soit parce que le prix ne reflète pas toute l’information nécessaire.
(1+i )2 =(1+i )(1+ie )
represents a relationship between different interest rates and their compounding effects. This equation is used in finance to understand how interest rates for different periods relate to each other.
Compounding effect
refer to the process where the value of an investment grows not only based on the initial principal amount but also on the accumulated interest from previous periods. This effect causes the investment to grow at an accelerating rate over time.
Quantitative easing as unorthodox monetary-policy option ?
-Zero lower bound for short-term interest rate
-Reduce interest of long-term bonds (given imperfect arbitrage)
Does Monetary will have an impact on the yield curve ?
Yes
Quantitative easing (QE) flattens the yield curve why ?
it involves large-scale purchases of long-term government bonds and other securities by a central bank
Orthodox monetary policy can shift the yield curve why ?
changes in interest rates set by a central bank.
Does Quantitative easing has an effect on inequality ?
By increasing asset prices, QE often benefits wealthier individuals and investors who hold stocks and bonds, potentially widening the wealth gap. Lower interest rates can also make borrowing cheaper, but this advantage may not be equally accessible to all income groups.
But it can also impact employement positively
In the short turn volatility of the stock prices cause ?
massive price changes
Change in the stock value
Stock price effect
increases if expected dividends are higher
decreases if interest rates are higher (today and in the future)
decreases if the risk premium is higher
a higher risk implies a higher equity premium and expected return.
a higher expected future real interest rate leads to a stronger discounting and thus to a lower real current stock price.
In Efficient-market hypothesis what about stock price?
stock prices cannot be predicted systematically (random walk)
Rational speculative bubbles
based on expectations of price increases
–> Possible that things (possibly without much fundamental value such as tulip bulbs) realize big capital gains through price increases (example house pricing)
expansionary monetary policy and stock prices on the LM
decrease of the LM courve
Expansionary monetary policy : Effect on stock prices
increase if monetary policy not anticipated
unchanged if monetary policy anticipated
Forward Guidance effect
Influence the yield curve by guiding interest-rate expectations
Forward Guidance definition
a monetary policy tool used by central banks to communicate their future policy intentions and economic outlook to influence market expectations and economic behavior.
If the current interest rate falls and all other determinants of stock prices remain constant, then
stock prices increase
Speculative bubbles may build in the stock market
if stock price gains are expected
Maturity
in finance refers to the date on which a financial instrument, such as a bond or a loan, is due to be repaid in full.
The Expectation Hypothesis
is a theory related to the term structure of interest rates, which helps explain the relationship between short-term and long-term interest rates. Under this hypothesis, the current long-term interest rate is essentially the average of current and expected future short-term interest rates.
unconventional monetary policy
Negative interest rates
The goal of unconventional monetary policy is..
to increase prices in specific bond markets.
The relationship between the maturity and the yield of bonds is known as..
the term structure of interest rates
Two basic dimensions in which bonds differ are:
default risk and the maturity.
What is the effect of Dte + 1 on the Qt
–> the higher the expected dividend De , the higher the stock price Q .
Calculate interest rate (i2t)
i2t = i1t + ie1+ t/ 2
If i2t is higher than i1t
The yield curve is upward
To determine the curve of a yied curve we should..
Difference between the interest rate of i1+t and i2t
The nominal present and expected future interest rates together with the present and future expected nominal payments determine.. ?
nominal bond prices
Realdiscountrate
r+x
Nominaldiscountrate=
i+x+π
Qt = Dt1 + Qet+1 / 1 + i1t + x
if we want to calculate Qt
zero coupon bound
is a type of bond that does not make periodic interest payments (or “coupons”) like regular bonds
The expectations hypothesis
implies that rational investors can predict future changes in interest rates by simply observing the yield spread
A safe bound
usually refers to a limit or a range that ensures safety or low risk in a given context.
example : U.S. Treasury bonds
Assume that a bond pays a fixed yearly amount of 100 CHF forever and the interest rate is expected to be zero forever. The present value of bond will be ?
The present value of this bond equals infinity
Forward guidance
is a tool used by central banks, like the Federal Reserve, to communicate the future direction of monetary policy. It gives the public clues about future interest rates to influence economic expectations and behaviors.
expectations hypothesis
financial investors care only about the expected return and do not care about risk
Under the assumption that you and other financial investors care only about expected return, it follows that the two bonds must offer the same expected one-year return.
Abritage between bonds of different maturities implies that…
bond prices are equal to the expected present values of payments on these bonds
yield to maturity/ n-year interest rate
is defined as the constant annual interest rate that makes the bond price today equal to the present value of future pay- ments on the bond
