Money and Banking Week 2

Chapter 6: The Risk and Term Structure of Interest Rates 1. The monthly rates on 10-year maturity Treasury bonds, 20-year maturity Treasury bonds, Aaa and Baa-rated corporate bonds (average over maturities) and 20-year maturity tate and !ocal bonds are sho"n belo".
Interest Rates on Various Bonds
10 9 8 7 6 5 4 3 2 1 2000-07 2001-07 2003-01 2004-01 2006-07 2007-01 2009-01 2009-07 2000-01 2001-01 2002-01 2002-07 2003-07 2004-07 2005-01 2005-07 2006-01 2007-07 2008-01 2008-07 2010-01 2010-07 2011-01 2011-07 0

Risk-free 10Y

Aaa

Baa

State

Risk free 20Y

The graph "ith the ris# and ta$ premia since 2000 is sho"n belo" (note% &or the ta$ premium the di&&erence "ith respect to 20-year maturity Treasury bonds "as ta#en). Baa rates bonds have a higher ris# premium than Aaa rated bonds, and the di&&erence bet"een the t"o ris# premia "as relatively large in 200'. (t is interesting to see that tate and !ocal bonds earned a higher interest rate than Treasury bonds &or most o& the post-200' period. This indicates that the de&ault ris# on tate and !ocal bonds "as higher than the ta$ advantage in 200'.

Risk and Tax Premia

7 6 5 4 3 2 1 0
20 00 20 -01 00 20 -07 01 20 -01 01 20 -07 02 20 -01 02 20 -07 03 20 -01 03 20 -07 04 20 -01 04 20 -07 05 20 -01 05 20 -07 06 20 -01 06 20 -07 07 20 -01 07 20 -07 08 20 -01 08 20 -07 09 20 -01 09 20 -07 10 20 -01 10 20 -07 11 20 -01 11 -0 7

-1 -2

Aaa risk premium

Baa risk premium

Tax premium 20y

2. The graph belo" clearly shoes that since the beginning o& 200) (and in particular the intensi&ication o& *ree# crisis in +ay 2010), the spreads have starter increasing dramatically. The belo" &igure highlights several note"orthy &eatures. ,irst, spreads &or *reece sharply decreased &rom about - percentage points at the start o& .+/ in 0anuary 1''' to small values &rom basically 2001 on"ards. That development is due to *reece1s entry into .+/ on 1 0anuary 2001 through "hich ris# on *ree# bonds "as assumed to decrease substantially (lo"er ris#, higher demand, higher prices and thus lo"er interest rates). econd, spreads to"ards *ermany &or the &ive countries under consideration bet"een 2001 and 2002 hovered around 0.2 to 0.3 percentage points. This indicates that mar#ets sa" government bonds o& these &ive nations as having only slightly more ris# than *erman bonds (that can be seen as virtually &ree o& de&ault ris#). Third, in the credit crisis period o& 200), spreads sharply increased &or the nations in 4uestion or mar#ets realised that these nations are more ris#y than *ermany. ,ourth, the end o& the credit crisis in 200' brought a drop in spreads as uncertainty decreased. ,i&th, since the beginning o& 2010, spreads increased sharply again as mar#ets realised that the high levels o& government debt may "ell become unsustainable in the countries in 4uestion. The rescue pac#ages &or *reece (&irst pac#age% +ay 2010, 110 billion .uro), (reland (5ecember 2010, )6 billion .uro) and 7ortugal (April 2011, 2) billion .uro) "ere unable to reduce &ears in the mar#ets. 8nly the re&orm pac#age in (reland no" seems to be able to reduce ris# premia. i$th, the &igure also sho"s the steep increase in ris# premia &or (taly in the past &e" months (in the meantime - 9ovember 2011) the spread &or (taly is around 6 percentage points.

PIIGS Spreads
18 16 14 12 10 8 6 4 2 0 *+,-2004 u'-2002 a!-1999 u!-2005 $%t-2000 Apr-2004 a!-2006 $%t-2007 u'-2009 Au"-1999 #ar-2000 &e%-2001 (e)-2003 Sep-2003 Au"-2006 #ar-2007 &e%-2008 #ay-2001 #ay-2008 Sep-2010 -2 (e)-2010 Apr-2011

-ree%e

.re'a!/

.ta'y

0+rtu"a'

Spai!

-. .$pectations theory o& the term structure a. An appro$imation o& the (three-year) e$pected return o& Strategy 1 is 1): ; (1<0.0=)(1<0.0=)(1<0.0=)-1>1. (i& calculated precisely it is 1'.10:) An appro$imation o& the e$pected return o& Strategy 2 is 1): ; (1<0.02)(1<0.0=) (1<0.06)-1>1. (i& calculated precisely it is 1'.0':) b. ame return. This is e$actly "hat you e$pect because the .$pectation Theory is based on the assumption that the t"o strategies (and bonds) are per&ect substitutes. 3. 5eriving a yield curve a. The yield curve can be plotted &rom the &ollo"ing one to three-year bond interest rates% i. 2:, 2.6:, -: ii. -:, -:, -: iii. 3:, -.6:, -: (9otice that i& "e #no" the term structure "e can easily recalculate the implied e$pected short-term rates). b. The yield curves "ill tend to rotate up"ards, because longer term bonds "ould have a positive li4uidity premium. c. The ne" one to three-year interest rates "ill be%

i. 2:, -:, 3: ii. -:, -.6:, 3: iii. 3:, 3:, 3: This speci&ic e$ercise gives a very good e$ample o& ho" the li4uidity premium tends to ?produce@ up"ard-sloping yield curves. 6. Dotted-line% Assuming higher li4uidity premia at longer maturities (as in e$ercise -), the &lat yield curve at shorter maturities suggests that short-term interest rates are e$pected to &all moderately in the near &uture. The steep yield at longer maturities indicates that short-term interest rates are e$pected to rise sharply. Because e$pected in&lation and interest rates move together (?,isher .&&ect@), the yield curve suggests that the mar#ets e$pect in&lation to &all moderately in the near &uture but to rise later on (assuming a &i$ed real interest rate r). Full-line% Assuming again higher li4uidity premia at longer maturities, the up"ard sloping yield curve at shorter maturities suggests that short-term interest rates are e$pected to stay constant or increase moderately in the near &uture. The do"n"ard sloping (or inverse) yield at longer maturities indicates that short-term interest rates are e$pected to &all sharply. Because e$pected in&lation and interest rates move together, the yield curve suggests that the mar#ets e$pect in&lation to stay the same or increase in the near &uture but to decline later on. 9otice that it is di&&icult to be precise because the precise level o& the li4uidity premium is not #no"n. =. ,rom the lin# provided in this e$ercise, you can observe that the current yield curve is up"ard sloping but steeper (at medium>long term maturities) than the yield curve one year ago. hort-term interest rates are similar but medium- and long-term interest rates "ere lo"er last year. The implied e$pected &uture short-term interest rates (or instantaneous &or"ard rates) can be directly observed by selecting ?instantaneous &or"ard@ (see the "eb-site &or &urther details and e$planations). ,uture short-term interest rates are e$pected to increase over the medium term but slightly decrease in the long term, but they are lo"er than one year ago. 2. The graphs are sho"n on the &ollo"ing page. The yield curves loo# very similar. hort-term interest rates are almost identical and medium- and long-term interest rates are not very di&&erent. .$planation% / , /A and *ermany are in almost identical economic situations right no", and the post-crisis situation (speed o& economic recovery and level o& &uture in&lation) is not e$pected to be very di&&erent &or the three countries.

/ %

/A%

*ermany%

Chapter 7: The Stock Market 1. *ordon *ro"th +odel a. The sum is evaluated until in&inity or it is assumed that the company "ill subsist inde&initely. This is in line "ith the ?going concern@ principle that you have encountered in your lectures on accountancy. The individual investor obviously has no in&inite li&espan, but that is unimportant &or the *ordon *ro"th model since that model is interested in valuing the stoc# price in &unction and then the relevant time horiBon is that o& the &irm. b. Ce thus have and

Thus, the discounted dividend "ill gro" to in&inity since its gro"th rate outpaces the discount &actor. As a result, the stoc# no" "ould have an in&initely high price as "ell, "hich obviously ma#es no sense. This is "hy "e assume that the dividend gro"th rate &alls belo" the re4uired return on investment in e4uity. c. 9o, dividends may gro" at a positive rate, may be constant over time and nothing prevents them &rom decreasing over time either (ta#e the e$ample o& a &irm in a sector that is in a secular decline). 9ote that "e can sa&ely assume that investors have a positive re4uired return on investment in e4uity. This and the negative gro"th rate o& the dividends together mean that the discounted dividend "ill gro" to"ards Bero over time or the &uture "ill contribute less and less to the value o& the stoc# price. (ts value thus "ill be determined &ully by the nearby &uture. Although "e assume that the dividend is decreasing, it can still yield a positive value &or the stoc# price. d. +ish#in argues that the *ordon *ro"th model has the &ollo"ing solution%

Ce start &rom%

This can be re"ritten as%

since "e assumed that dividends in the &uture are simply given by the current dividend multiplied by some &actor. Ce subse4uently bring also in &ront or "e obtain%

and thus%

Ce can "rite this more compactly by de&ining

"hich allo"s us to "rite% The terms "ithin s4uared brac#ets is a so-called po"er series o& "hich "e #no" that

Thus

The de&inition o& then gives%

and thus

Ce encountered earlier on that g

. This is in line "ith the above condition that

This &ormula &or the price o& the stoc# yields straight&or"ard insights in the e&&ect that changes in the re4uired return on investment in e4uity generate &or the stoc# price. e. An increase in means that investors re4uire a higher re4uired return on investment in

e4uity "hen discounting &uture income streams to"ards the present point o& time. They thus desire a higher rate o& return in order &or instance to compensate them &or higher perceived ris#. The heavier the discounting o& &uture income streams "ill be, the smaller the present value o& the stoc# price "ill be. (ntuitively, the stoc# is less attractive "hen it is associated "ith higher ris# and then, other things being e4ual, it "ill be valued at a lo"er price. ,ormally, "e used an intuitive version o& a traditional comparative-statics argument &or "hich "e typically calculate derivatives. (n this case, "e need the derivative o& the price to the re4uired return on investment in e4uity%

The price e4uation o& the *ordon *ro"th model can also be used to discuss the e&&ects o& &or instance e$pansionary monetary policy on stoc# prices. Typically, it is argued that a lo"er interest rate increases , reduces and increases .

A lo"er interest rate can be e$pected to &uel economic activity and thus the operating income o& &irms. (t then is a logical step to assume that the ne$t period1s dividend stream also "ill increase. A decrease in interest rates should decrease the return on bonds and thus, ceteris paribus, ma#e investments in stoc#s more attractive through "hich investors "ould re4uire a lo"er re4uired return on investment in e4uity. The supposed &urthering o& economic activity is li#ely to drive up &uture dividends and thus steps up their gro"th rate. 2. The &orecast error is the discrepancy bet"een the &orecasted value and the realiBation. (& "e have rational e$pectations, the e$pectation o& a variable is the optimal &orecast given all available in&ormation. 5iscrepancies bet"een that e$pectation and the observed value must be due to chance. (& "e "ould not on average be correct in our e$pectation, i.e. "hen "e "ould ma#e systematic errors, e$pectations are not rational. 7hrased di&&erently, they then seem not to be the optimal &orecast. +oreover, any discrepancy bet"een the &orecasted value and the realiBation should not be predictable. (& such errors "ere predictable, it "ould be clear that the model that "e used to come up "ith our guess is not the best one possible. Dhanging the model that "e used could yield superior &orecasts. -. The e&&icient mar#et hypothesis (.+E) is tantamount to stating that no une$ploited arbitrage opportunities e$ist. The .+E means that prices should move instantaneously to their e4uilibrium. !asting di&&erences bet"een observed prices and e4uilibrium prices should not e$ist since that "ould obviously violate the entire concept o& mar#ets being e&&icient. 7hrased di&&erently, "e need a mechanism to ensure that any such di&&erences bet"een observed prices and e4uilibrium prices s"i&tly disappear. This precisely is the role o& arbitrageurs. They basically are on the loo#out &or so-called arbitrage opportunities or di&&erences bet"een actual and e4uilibrium prices. uppose that they &ind that some stoc# is trading belo" its e4uilibrium value, the stoc# "ill be bought in order to later sell it at its higher e4uilibrium price. This "ould have t"o e&&ects. ,irst, the actual price o& the stoc# through the buying operation o& the arbitrageur "ill increase to"ards the e4uilibrium price. econd, the arbitrageur thus can ma#e a pro&it &rom such une$ploited arbitrage opportunities. They thus give him>her a so-called &ree lunch. Thus, they can ma#e gains. 3. A bubble means that prices di&&er &rom the so-called &undamentals. ,undamentals are all variables that together determine the value o& some asset (e.g. the pro&its o& the &irms, its patents and thus &uture pro&itability, etc). uppose that the stoc# price is &ar above its &undamental or e4uilibrium value. Ce thus #no" that there is a bubble, but it still can be a

rational strategy to #eep on buying that stoc# i& "e can believe that the stoc# price "ill even increase &urther. Ce "ould use such strategy since "e assume either naively that the bubble "ill continue or more realistically that "e "ill be able to sell be&ore the bubble &inally bursts.