European Macroeconomics

BA Course
University College London, SSEES

Lecture 4 – Financial markets and expectations

Dr. Yuemei Ji
yuemei.ji@ucl.ac.uk
Objective of this lecture
CHAPTER 16:
FINANCIAL MARKETS AND EXPECTATIONS

Understanding well macroeconomic developments and

policies requires a basic knowledge of some finance
concepts

Financial markets not only include bond market (we

discussed in the money demand model), but also stock
market
Plan of the lecture
1. Valuing assets – Present Discounted Value (basic
computation)
2. Bond markets and prices
3. Stock markets and prices
4. Risk, Bubbles, Fads and Asset Prices: two schools
of views
• You will have 1 million pound in two years, the
interest rate for this year is 2%, the rate for next
year is 3%. What is the PRESENT VALUE of 1
million pound?
a) 1million pound
b) 0.98 million pound
c) About 0.9518 million pound
d) 1.0506 million pound

4
Computing expected present discounted values

(a) One euro this year is (c) One euro is worth (1  it )(1  it 1 )
worth 1+it euros next euros two years from now.
year.
(b) If you lend/borrow 1/(1+it) (d) The present discounted value of a
euros this year, you will euro two years from today is
receive/repay 1 equal to 1 .
(1 + i ) = 1
t
(1 + it ) [(1 + it )(1 + it + 1 )]
euro next year.
1. The word ‘discounted’ comes from the fact that the value next
year is discounted, with (1+it) being the discount factor.
The 1-year nominal interest rate, it , is sometimes called the
discount rate.

2. Now let’s do another exercise, in which you will get a

sequence of future payments. Consider one asset you have.
It could be a property or some shares of a company. Annual
payments are called rent or dividend.

What is the expected present discounted value of these

payments? See the next slides
The general formula
• The present discounted value of a sequence of
payments, or value in today’s euros equals:

• When future payments or interest rates are

uncertain, then:

• Present discounted value (or present value) is

another way of saying ‘expected present discounted
value’.
This formula has two implications:

• Present value depends positively on today’s

actual payment and expected future
payments.

• Present value depends negatively on current

and expected future interest rates.
Present Values: constant interest rates
To focus on the effects of the sequence of payments on
the present value, assume that (1) interest rates are
expected to be constant over time; (2) payments start
next year and go on forever

When the sequence of payments is equal—called them

€z, the present value formula simplifies to:
1 1
€𝑉𝑡 = €𝑧𝑡 ∗ 1 + + ⋯+ 𝑛−1
+⋯
1+𝑖 1+𝑖
 The Vocabulary of Bond Markets
• Face value of a bond: it is the amount paid to the holder at
maturity.
• Maturity: the length of time over which the bond promises to
make payments to the holder of the bond.
• Bonds that promise multiple payments before maturity and
one payment at maturity are called coupon bonds.
 The payments for each period are called coupon
payments.
 The ratio of the coupon payments to the face value of the
bond is called the coupon rate.
 The life of a bond is the amount of time left until the bond
matures.
• Bonds that promise a single payment at maturity are called
discount bonds/Zero coupon bonds.
 Bond Prices and Bond Yields
Bonds differ in two basic dimensions:
• Default risk: the risk that the issuer of the bond will not pay
back the full amount promised by the bond.
• Maturity: the length of time over which the bond promises
to make payments to the holder of the bond.

Bonds of different maturities each have a price and an

associated interest rate called the yield to maturity, or
simply the yield.
 Default risk

• Bond ratings are issued by Standard and Poor’s

Corporation and Moody’s Investors Service.
 Bonds with high default risk are often called
junk bonds.
• Corporate bonds are bonds issued by firms.
• Government bonds are bonds issued by
government agencies (some government for
example US government bond is assumed to be
risk-free)

12
 Maturity and yield
The relation between maturity and yield is called the
yield curve or the term structure of interest rates.

Question: what
makes the yield
curve different?
We will return to
this question later

UK yield curves: June 2007 and May 2009

The yield curve, which was slightly downward-sloping in June 2007, was sharply
upward-sloping in May 2009.
Source: Bank of England.
Example: Bond Price and Yield
• The Greek government issued coupon bonds of 15 year
maturity. Face value 100 euro, coupon rate 4%. For a
bondholder of 1 unit of this bond, it means that every year,
the government will pay the bondholder 4 euro and at the
end of the maturity Greek government will also pay back
100 euro.
• After 5 years in 2011 when debt crisis in Greece
deteriorated, the market price of that bond dropped to 50
euro.
• The current yield is 100*4%/50=8%
• If investors buy the bond at 50 euro in 2011, and hold it
until maturity in 10 year, the yield to maturity is 13%
(according to the market information see the next slide)
14
Long-term govt. bond yields in Eurozone, 1995-2011 (in percent)
Cash flow for the
bondholder Euro
Note: The yield to maturity on an n-year
year 0 (at the time bond, or the n-year interest rate, is the
of purchase) -50 constant annual interest rate that makes
year 1 4 the bond price today equal to the present
year 2 4 value of future payments of the bond.
year 3 4
year 4 4 Bond Price P at the time
𝑃
year 5 4 4 4 4
year 6 4 = + +
(1 + 13%) (1 + 13%)2 (1 + 13%)3
year 7 4 4 100 + 4
year 8 4 + ⋯+ +
1 + 13% 9 (1 + 13%)10
year 9 4 =50
year 10 104
yield to maturity This formula can be generalized
(internal rate of
return) 13%
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Bond Prices as present value
Consider two types of bonds (both are zero
coupon bonds):

• A one-year bond—a bond that promises one payment of

€100 in one year. Price of the one-year bond:

• A two-year bond—a bond that promises one payment of

€100 in two years. Price of the two-year bond:
Arbitrage and Bond Prices: Which bond of the following
should you hold if you only want to hold for one year?
For every euro you put in one-
year bonds, you will get (1+ i1t)
euros next year.

For every euro you put in two-

year bonds, you can expect to
receive € 1/ € P2t times € P e
1t+1
euros next year.

If you hold a two-year bond, the price (𝑷𝒆𝟏+𝒕 ) at

which you will sell it next year is uncertain—risky.
Arbitrage and Bond Prices

• The expectations hypothesis states that investors care

only about expected return. i.e. they are risk neutral
• If two bonds offer the same expected one-year return,
then:

Return per euro Expected return

from holding a per euro from
one-year bond for holding a two-year
one year. bond for one year.
• No-arbitrage relations are relations that make the returns
on two assets equal.
– Just consider if the returns are different, investors can
buy low and sell high to make profit.
– This will affect the demand for two-year bond against
the demand for one-year bond, hence adjust P2t
– This difference in return will disappear so that no
arbitrage can occur

• This implies that the price of a two-year bond today is the

present value of the expected price of the bond next year.
𝑒
𝑃1𝑡+1
𝑃2𝑡 =
1+𝑖1𝑡
Bond Yields calculation
The yield to maturity on an n-year bond, or the n-year interest rate, is
the constant annual interest rate that makes the bond price today
equal to the present value of future payments of the bond. (We have
shown the Greek bond example earlier)
Let us define the yield of a 2-year bond, i2t

, then:

therefore:

From here, we can solve for i2t.

Bond Prices and Bond Yields
e.g. 0.03*0.05=0.0015≈0

1  i2t 2
 (1  i1t )(1  i1et 1 )  1  i1t  i1et 1  i1t i1et 1  1  i1t  i1et 1
 1  2i2 t  i2 t i2 t  1  2i2 t
≈0

1
Thus: i2t  (i1t  i1et 1 )
2
the two-year yield rate i2t is (approximately) the average of the current
one-year rate and next year’s expected one-year rate.
Long-term interest rates reflect current and future expected short-term
interest rates.
• An upward sloping yield curve means that long-term
interest rates are higher than short-term interest rates.
Financial markets expect short-term rates to be higher
in the future.
• A downward sloping yield curve means that long-term
interest rates are lower than short-term interest rates.
Financial markets expect short-term rates to be lower in
the future.
• Using the following equation, you can find out what
financial markets expect the 1-year interest rate to be 1
year from now:
We usually can check
this rate in the bond
i1et 1  2i2t  i1t markets, see the next
slide
UK yield curves: June 2007 and May 2009
The yield curve, which was slightly downward-sloping in June 2007, was sharply
upward-sloping in May 2009.
Source: Bank of England.
 The UK economy as of June 2007

The yield curve and economic activity (yield curve blue on page 24,
long-term yield is practically the same as the short-term yield)
 The yield curve and economic activity (yield curve purple, sharp drop
from the blue curve on page 24)

The UK economy from June 2007 to May 2009

Figure 16.8
From June 2007 to May 2009, a sharp reduction in spending, together with a
monetary expansion, combined to lead to a decrease in the short-term interest rate.
The yield curve and economic activity (the purple yield curve upward slopping)

Financial markets
expected two main
developments:

• They expected a pickup

in spending-a shift of
the IS curve to the
right, from IS to IS.
• They also expected
that, once the IS curve
started shifting to the
right and output started
to recover, the central
bank would start
shifting back to a tighter
monetary policy.

In May 2009, financial markets expected that the economic stimulus stemming from
monetary and fiscal policies would lead to a recovery in economic growth, hence to
higher interest rates in the future.
The Stock Market and Stock Prices
Firms raise funds in two ways:

• Through debt finance—bonds and loans; and

• Through equity finance, through issues of stocks—or

shares. The shareholders ‘own’ part of the firm

• Instead of paying predetermined amounts as bonds do, stocks

pay dividends in an amount decided by the firm.
 The Stock Market and Stock Prices
Stock prices as present values

The price of a stock must equal the present value of

future expected dividends, or the present value of
the dividend next year, of two years from now, and
so on:

€ Dte1 € Dte 2
€Qt   
1  i1t 1  i1t  1  i1t 1 
e
 The Stock Market and Stock Prices
Stock prices as present values
How do we know
the value of
Det 1 Det  2 expectation? In
Qt    fact, stock
(1  r1t ) (1  r1t )(1  r 1t 1 )
e
market flactuate
significantly
This relation has two important implications:

• Higher expected future real dividends lead to a higher

real stock price.

• Higher current and expected future one-year real interest

rates lead to a lower real stock price.
 The Stock Market and Stock Prices
Det 1 Det  2
Qt   
(1  r1t ) (1  r1t )(1  r 1t 1 )
e

Note also one can re-write the equation as

Dte1 Qte1
Qt  
(1  r1t ) (1  r1t )
Dte 2 Dte3
where Q  e
t 1   ...
(1  r1t 1 ) (1  r2t 1 )(1  r3t 1 )
e e e

The stock price today reflects the sum of future dividends,

or equivalently, tomorrow’s dividend and the stock price
tomorrow.
If a firm makes profits but does not distribute
dividends, these profits accumulate as savings of
the firm, and increases its value because it
increases expected dividends later on.
In practice 70 percent of firms do not distribute dividends
because of tax reasons (so all profits accrue to the stock
price – capital gains are taxed less than income in the US)

32
Efficient Market Hypothesis (EMH) and
Stock Prices
1. In 1965 Samuelson proved that in an efficient market, stock
prices should follow a random walk. It takes the following form,
the movement of the stock price 𝛆𝑡+1 is unpredictable.
𝑄𝑡+1 = 𝑄𝑡 + 𝛆𝑡+1
where 𝛆𝑡+1 is white noise
𝛆𝑡+1 ~(0, 𝜎 2 )
2. Why is that? Because if a price increase was predictable
given the existing information, you would buy large amounts
of it, and make a huge profit. By doing it, you would be driving
the price up to the point where they would be no predictable
increase in the price of the share. This is what we call “non-
arbitrage condition”
Do stock markets respond to monetary policy and
fiscal policy?
• These policy can affect the dividend and interest rate in
the present value formula.

Det 1 Det  2
Qt   
(1  r1t ) (1  r1t )(1  r 1t 1 )
e

We will look into details. See the next slides related

to the stock market and economic activity

34
1. A monetary expansion and the stock market

A monetary expansion decreases the interest rate and increases output.

What it does to the stock market depends on whether financial markets
anticipated the monetary expansion. If it is not anticipated, stock prices go
up. If is anticipated, stock prices won’t change.
2. An increase in consumer spending and the stock market

There are several things the central bank may do after

receiving news of strong economic activity:
• They may keep the same monetary policy, leaving the LM curve
unchanged, causing the economy to move along the LM curve.
• Stock prices uncertain: depend on the slop of LM curveFigure 16.14
(a)(b)

• Or the central bank may worry that an increase in output above

YA may lead to an increase in inflation.
• Stock prices go down Figure 16.14 (c), LM’’

• They may accommodate, or increase the money supply in line

with money demand, so as to avoid an increase in the interest
rate. An example of central bank accommodation is shown in
Figure 16.14(c). LM’
• Stock prices go up
 An increase in consumption spending and the stock market
Figure 16.14a
The increase in consumption spending leads to a higher interest rate and a higher
level of output. What happens to the stock market depends on the slope of the LM
curve and on the central bank’s behaviour.
An increase in consumer spending and the stock market

An increase in consumption spending and the stock market

Figure 16.14b
If the LM curve is steep, the interest rate increases a lot, and output increases little.
Stock prices go down. If the LM curve is flat, the interest rate increases little and
output increases a lot. Stock prices go up.
 An increase in consumer spending and the stock market

An increase in consumption spending and the stock market

Figure 16.14c
If the central bank increases the amount of money in the economy, the interest rate
does not increase, but output does. Stock prices go up. For example, in the past
during boom years, the previous Fed chairman Greenspan had accommodating
monetary policy and the stock market had a bull for some period. If the central bank
decides instead to keep output constant, the interest rate increases, but output does
not. Stock prices go down.
 Risk, Bubbles, Fads and Asset Prices
• Stock prices are not always equal to their fundamental value, or the
present value of expected dividends. This is a very complex issue!

• Rational speculative bubbles occur when stock prices increase just

because investors expected them to. Recall:
Dte1 Qte1
Qt  
(1  r1t ) (1  r1t )
Dte 2 Dte3
where Q e
t 1    ...
(1  r1t 1 ) (1  r2t 1 )(1  r3t 1 )
e e e

Dte 2 Qte 2
 
(1  r1t 1 ) (1  r1et1 )
e

Deviations of stock prices from their fundamental

value are called fads.
Bubble in the US stock market

41
Famous Bubbles: From Tulipmania in Seventeenth-
Century Holland to Russia in 1994, and now Bitcoin

Tulipmania in Holland
In the seventeenth century, tulips became increasingly popular in Western
European gardens. A market developed in Holland for both rare and
common forms of tulip bulbs.
The Pyramid Scheme in Russia (a Ponzi-scheme, a la Madoff)
In 1994 a Russian ‘financier’, Sergei Mavrody, created a company called
MMM and proceeded to sell shares, promising shareholders a rate of
return of at least 3,000% per year!
The trouble was that the company was not involved in any type of
production and held no assets, except for its 140 offices in Russia. The
shares were intrinsically worthless. The company’s initial success was
based on a standard pyramid scheme, with MMM using the funds from
the sale of new shares to pay the promised returns on the old shares.
BITCOIN
Real house prices in advanced economy: bubbles?
 Two schools of views on financial markets
• Assets pricing in financial markets is very complex, there are two schools
of thinking
1) Traditional view:
a) Rational Expectation
b) Efficient market: Economic fundamentals such as dividends matter
for stock prices.

2) Behavioural Finance:
a) Psychological factors play a role
b) financial markets are not efficient, booms and busts occur, and
prices can deviate from fundamentals

• Although economists find empirical evidence of 60s-90s to support

efficient market view, more recent empirical evidence does not support
the traditional view. Especially in the post financial crisis period,
behavioural finance views seem to obtain wide support from economists
and other social scientists. 44
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