1) Bonds differ based on their risk profile and maturity. Government and corporate bonds have different default and price risks. Bonds also vary in their maturity, which impacts their price and yield.
2) The yield curve plots the relationship between yields on bonds of different maturities. A downward sloping yield curve occurs when short term interest rates are expected to decrease in the future.
3) Consumption is determined by current disposable income, expected future disposable income, and financial wealth. Changes in expectations of future income can impact current consumption levels.
1) Bonds differ based on their risk profile and maturity. Government and corporate bonds have different default and price risks. Bonds also vary in their maturity, which impacts their price and yield.
2) The yield curve plots the relationship between yields on bonds of different maturities. A downward sloping yield curve occurs when short term interest rates are expected to decrease in the future.
3) Consumption is determined by current disposable income, expected future disposable income, and financial wealth. Changes in expectations of future income can impact current consumption levels.
1) Bonds differ based on their risk profile and maturity. Government and corporate bonds have different default and price risks. Bonds also vary in their maturity, which impacts their price and yield.
2) The yield curve plots the relationship between yields on bonds of different maturities. A downward sloping yield curve occurs when short term interest rates are expected to decrease in the future.
3) Consumption is determined by current disposable income, expected future disposable income, and financial wealth. Changes in expectations of future income can impact current consumption levels.
1) Bonds differ based on their risk profile and maturity. Government and corporate bonds have different default and price risks. Bonds also vary in their maturity, which impacts their price and yield.
2) The yield curve plots the relationship between yields on bonds of different maturities. A downward sloping yield curve occurs when short term interest rates are expected to decrease in the future.
3) Consumption is determined by current disposable income, expected future disposable income, and financial wealth. Changes in expectations of future income can impact current consumption levels.
BONDS Types of issuers: • Government bonds • Corporate bonds Types of bonds: • Discount bonds • Coupon bonds Bonds differ by: • Risk profile o Default risk o Price risk • Maturity o Price o Interest rate (yield)
YIELD CURVE
YIELD (n-year interest rate) – int
Definition: the constant annual interest rate such that the price of a bond equals to the Present Discounted Value (PDV) where n = the number of years to maturity
For example: €100 €𝑃#$ = (1 + 𝑖#$ )(1 + 𝑖#$ ) Where i2t = 2-year interest rate
0 𝑖.$ + 𝑖.$/. 𝑖#$ ≈ 2 (the average of the interest rate today and the expected interest rate at time t+1 with NO RISK)
0 𝑖.$ + 𝑖.$/. +𝑥 𝑖#$ ≈ 2 (the average of the interest rate today and the expected interest rate at time t+1 with RISK PREMIUM) YIELD CURVE WITH RISK VS. WITH NO RISK
Yield/Interest rate
1 2 Maturity (in years)
RISKY bond (constant interest rate)
NO RISK bond (constant interest rate)
DOWNWARD SLOPING YIELD CURVE
Yield/Interest rate
1 2 Maturity (in years)
NO RISK (expect lower interest rate in the future)
0 𝑖.$/. < 𝑖.$ ⟹ this occurs when the economy is going into a recession
EXPECTATIONS IN THE STOCK MARKET – EQUITY FINANCE
Equity finance: issuing stocks or shares that pay dividends
Variables: 0 • Ex-dividend price (price of the stock after the firm has distributed dividends) = €𝐷$/. • Price of stock = €𝑄$ 0 • Price of the stock if it is re-sold in the future = €𝑄$/. Value of stock at time t+1: 0 0 €𝐷$/. + €𝑄$/. €𝑄$
**N.B.** 𝐷$ is not considered in the equation because it has already been paid
In general:
In real terms:
RATIONAL BUBBLE When the price of stocks increases because agents expect an increase in price therefore it is not a realistic increase in price as all agents know that the stocks are being overvalued. The price usually keeps increasing until a collapse creating uncertainty about the prospects of a firm.
CONSUMPTION AND EXPECTATIONS
𝐶 (𝑌9 ) = 𝐶$ (𝑌$ − 𝑇$ ) Consumption determinants: + + • Wealth = 𝐶$ Wealth determinants: • Financial and housing wealth = 𝑊𝐹𝐻$ • Human wealth (labour income or disposable income) = 𝑌9 = 𝑌$ − 𝑇$ • PDV of human wealth = 𝑌90 = 𝑌$/. 0 0 − 𝑇$/. MICROFOUNDATION OF CONSUMERS AND EXPECTATIONS Assumptions: • 2 periods o t o t+1 • regular preferences (𝑈(𝐶$ , 𝐶$/. ) • access to banks ⟹ r = interest rate of loans • 𝑊𝐹𝐻$ = 0
Slope of the equation = −(1 + 𝑟) = relative price of consumption today in relation to consumption tomorrow ⟹ the opportunity cost of money Y-intercept = (1 + 𝑟) ∙ 𝐻𝑊$ X-intercept = 𝐻𝑊$
Suppose ( 𝑌$ − 𝑇$ ) ↑ ⟹ shift of the IBC outwards and ∆( 𝑌$ − 𝑇$ ) > ∆𝐶$
0 0 Suppose (𝑌$/. − 𝑇$/. ) ↑ ⟹ shift of the IBC outwards and ∆𝑌9 = 0 Suppose 𝑟 ↑ ⟹ 1 + 𝑟) ↑ ⟹ 𝐶$ ↓ and 𝐶$/. ↑ (substitution effect) ⟹ borrowers become poorer ( and savers become richer (income effect)
Determinants of 𝐶$ : 0 0 𝐶$ ( 𝑌$ − 𝑇$ ; 𝑌$/. − 𝑇$/. ; 𝑊𝐹𝐻$ ) + + + Determinants of 𝑊𝐹𝐻$ : • Values of houses in time t • 𝑃JKL9MN • 𝑄$ Observations: i. 𝐶$ responds less than proportional to changes in 𝑌9 ⟹ consumption today increases less than the increase in disposable income today ii. 𝐶$ changes even when ∆𝑌9 = 0 ⟹ income is not changing today but expected to increase tomorrow causing increase in consumption today iii. 𝐶$ changes more than predicted in response to changes in ∆𝑌9 ⟹ impact different from the one expected, for example: ∆( 𝑌$ − 𝑇$ ) = ∆𝐶$ **N.B. ** this occurs when people are credit constrained and there is a transitory shock
INVESTMENT AND EXPECTATIONS
𝐼$ = 𝐼(𝑌$ ; 𝑟$ ) Where: + - • 𝑌$ = level of sales at time t • 𝑟$ = real interest rate (cost of buying bonds)
COST BENEFIT ANALYSIS
Definition: compare benefits (expected return) received from investment at time t+1 with the cost of the investment at time t
Variables: 0 • Expected return of the investment per unit of capital = 𝜋$/. • Depreciation rate = 𝛿 < 1
Present value of expected return (profits) for one unit of capital:
Today’s value of future expected profits corrected by depreciation:
Determinants of investment function:
When 𝑉 (𝜋𝑒𝑡 ) > 1 ⟹ invest
When 𝑉 (𝜋𝑒𝑡 ) < 1 ⟹ do not invest When 𝑉 (𝜋𝑒𝑡 ) = 1 ⟹ indifferent between investing and not investing SPECIAL CASE – static (constant) expectations and real interest rate
Today’s value of future expected profits corrected by depreciation:
Where 𝑟$ + 𝛿 = cost of borrowing (rental cost of capital) or shadow cost ⟹ opportunity cost of investing that money
The IS equation with expectations has the same slope as the baseline model but the slope is steeper as 𝑌$ depends on future expectation as well as the values at time t therefore sensitivity is smaller so (𝑐. ) and (𝑐. − 𝑑. ) are smaller.
**N.B.** it is very important to differentiate between a TRANSITORY/TEMPORARY and a
PERMANENT policy as the latter causes expectations to change so it is necessary to use two graphs (one representing period t and the other period t+1) to understand the effects of changes in expectation today (at time t)
0 0 **N.B.** changes in 𝐺$/. do not cause a change in 𝐶$ whilst changes in 𝑇$/. cause changes in 𝐶$ as it is found in the list of determinants of 𝐶$
