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Chapter 18
Financial Markets and Asset Prices

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McGraw-Hill/Irwin
Macroeconomics, 10e

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2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

Introduction

Financial markets link the macroeconomy and

government policy directly to the lives of everyday
people

Changes in interest rates affect our ability to finance a home, car

Movements in the stock market determine the value of pensions

In this chapter we examine the behavior of three financial

markets:

Bond market
Stock market
Foreign exchange market
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Interest Rates: Long and Short Term

Interest rates summarize the promised repayment terms

on bonds, loans not just one interest rate

Interest rates differ according to:

Credit worthiness of issuer

Tax treatments
Risk
Term
Other factors

The factor of greatest focus here is the term or the length

of time the interest rate covers

The relation between interest rates of different maturities is

called the term structure of interest
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Interest Rates: Long and Short Term

Figure 18-1 shows interest

rates for U.S. Treasury
securities from 3 months to 30
years

[insert Figure 18-1 here]

Interest rates of different

maturities mostly go up and down
together
The gap between long term rates
and short-term rates varies
Long-term rates are usually higher
than short-term rates

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Interest Rates: Long and Short Term

Consider the relation between the 1-year and 3-year rates (today is
January 1, 2020)

You have the option of:

Making a three year investment today and earning 3i2020 each year OR
Investing for one year, reinvesting for another year at the prevailing rate at
the beginning of 2021, and doing the same at the beginning of 2022

[Insert Figure 18-2 here]

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Interest Rates: Long and Short Term

If all of the rates in Figure 18-2 were known in advance, the total
returns would be equal for both options
If the total returns were not equal, everyone would invest in the alternative
with the greatest return
(1 i20201 i20211 i2022)
illustrates the idea of ARBITRAGE: 3 i2020
3

The long-term interest rate equals the average of current

and future short-term interest rates.

[Insert Figure 18-2 here]

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Interest Rates: Long and Short Term

The problem is, in 2020 we do not know 1i2021 or 1i2022

with certainty

Need to modify our equation in two ways:

Todays long-term rate depends on the current short-term rate and

the expected future short-term rates
Uncertainty implies risk, and long-term investments command a
term premium, PR, to compensate for this risk

The term structure equation becomes:

3 2020

e
e
(1)

i
2020 1 2021 1 2022
PR
3

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Interest Rates: Long and Short Term

1 2020

3 2020

e
e
1 i2021
1 i2022
PR
3

Table 18-1 shows the average

term premiums based on the
interest rates shown in Figure
18-1

Equation (1) shows the

expectations theory of the term
structure
Term premiums vary over time,
but are generally higher for
longer-term rates

[Insert Table 18-1 here]

[Insert Figure 18-1 here, again]

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The Yield Curve

Interest rates for different

maturities are illustrated by the
yield curve Figure 18-3

[Insert Figure 18-3 here]

Typically upward sloping since

long-term rates are generally
higher than short-run rates
If yield curve slopes downward,
indicates financial markets expect
interest rates to fall
Often a recessionary signal
Indicates the market
anticipates a coming drop in
interest rates

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Bond Prices and Yields

Bond prices are inversely related to interest rates

If a bond is to pay $100 a year from now and has an interest rate i, then its price, P, must be such
that:

P (1 i ) 100 P

100

(1 i )

Ex. A $100 bond will have a 5% yield if its price is $95.24

Specific Example : Suppose you buy a bond with a coupon of $5 at the end of year 1 and again
at the end of year 2, plus a $100 return of principal at the end of year 2.
Price of this bond = $100 = [ 5 / (1 + 0.05) ] + [ 5 / (1 + 0.05)2 ] + [ 100 / (1 + 0.05)2 ]
When a bond price equals its face value, the bond is said to trade at par.
Suppose that an instant after you purchased the bond, i rises from 5% to 10%
In order to sell your bond, you must now compensate the buyer for the lower coupons of $5
on this bond as compared to a brand new $100 bond which will offer coupons of $10 .
Hence, your (old) bond will now sell at a lower price of :
$ 91.32 = [ 5 / (1 + 0.10) ] + [ 5 / (1 + 0.10)2 ] + [ 100 / (1 + 0.10)2 ]
The longer the term of the bond, the greater the required change in the price to
compensate for a change in the interest rate.

Long term bonds are subject to considerable price fluctuations.

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