Intermediate Macroeconomics

Chapter 17

Financial Markets

Intermediate Macroeconomics

Financial Markets

• Three Markets:– Bond Market (yield curve)– Stock Market (random walk)– Foreign Exchange Market

(exchange rates and interest rates)

• Key Concepts:– Forward Looking– Arbitrage

Intermediate Macroeconomics

Arbitrage

In equilibrium, investors must be equally willing to buy or sell an asset.

There must be no unrealized profit (arbitrage) opportunities

Intermediate Macroeconomics

Bond Market

• Price of a Bond

• Term Structure of Interest Rates

• Typical Market Conditions

• Normal Yield Curve

• Inverted Yield Curve

• Interest Rate Volatility

Intermediate Macroeconomics

Price of a Bond

• Price = net present value of bond’s cash-invalue (forward looking)

= bond face value discounted by

nominal interest rate

• Long-Term Nominal Interest Rate

= average of current and expected

future short-term interest rates

• Term of a Bond = years to maturity

Intermediate Macroeconomics

Term Structure of Interest Rates

• Term Structure - relationship between short-term interest rate (rate on a 6-month T-Bill) and long-term interest rate (rate on a 30-year T-Bill)

– Normal Yield Curve: long-term interest rates are higher

– Flat Yield Curve: short-term and long-term interest rates are identical

– Inverted Yield Curve: short-term interest rates are higher

Intermediate Macroeconomics

Interest Rate Term Premium30 year T-Bill - 1 year T-Bill

-4

-3

-2

-1

0

1

2

3

4

5

Jan-77 Jan-80 Jan-83 Jan-86 Jan-89 Jan-92 Jan-95 Jan-98 Jan-01

Inte

rest

Rat

e D

iffe

ren

ce,

per

cen

t Oct. 1992

Feb. 2000

Mar. 1980

Intermediate Macroeconomics

T-Bill Yield Curve

0

2

4

6

8

10

12

14

16

18

0 5 10 15 20 25 30

Years to Maturity

Inte

rest

Rat

e, p

erce

nt

Mar. 1980

Oct. 1992

Feb. 2000

Intermediate Macroeconomics

Variables that influence Term Structure

• Expected Inflation– Normal curve - expect increase in inflation rate– Inverted curve - expect decline in inflation rate

• Relative Risk– normal curve - longer term assets are riskier

require higher rate of return– inverted curve - short term rates are more volatile

Intermediate Macroeconomics

Stock Price Random Walk

• Price of a Stock• Changes in Stock Market Prices

– unexpected changes in market information

• Implications– expected economic growth– technological innovation– you can’t outperform the market

• Typical Market Conditions– stock price volatility– stocks outperform bonds