Intermediate Macroeconomics Chapter 17 Financial Markets Financial Markets

Intermediate Macroeconomics Chapter 17 Financial Markets

Financial Markets • Three Markets: – Bond Market (yield curve) – Stock Market (random walk) – Foreign Exchange Market (exchange rates and interest rates) • Key Concepts: – Forward Looking Intermediate Macroeconomics – Arbitrage

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-in value (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 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 longterm interest rates are identical – Inverted Yield Curve: short-term interest rates are higher Intermediate Macroeconomics

Interest Rate Term Premium 30 year T-Bill - 1 year T-Bill Oct. 1992 Feb. 2000 Mar. 1980 Intermediate Macroeconomics

T-Bill Yield Curve 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 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 Intermediate Macroeconomics