Prepare 4 or 5 slides explaining the different aspects related to behavioral finance: momentum & mean Reversion, herd behavior and bubblles

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MACROECONOMICS UNDERSTANDINGTHE GLOBAL ECONOMY

Bond & Equity Markets

Ch. 16

Modified by Prof. N. Dans

Copyright © 2012 John Wiley & Sons, Inc. All rights reserved.

16-2

Key Concepts

 Global Financial Assets

 Equities

 Determination of Stock Prices

 Risk and Speculation

 Bond markets

 Prices and Yields

 Relationship to monetary policy

 Use of the yield curve to anticipate future economic events

16-3

What are Financial Markets?

 It is often used to refer just to the markets that are used to raise finance:

 for short-term finance =>Money markets.

 for long-term finance => Capital markets.

Stock markets:

◦ provide financing through the issuance of shares

◦ enable the subsequent trading thereof.

Bond markets:

◦ provide financing through the issuance of bonds

◦ enable the subsequent trading thereof.

16-4

Global Financial Assets

Financial assets made of Bank Deposits, Debt Securities (government and private) and Equities now worth more than 350% of global GDP

0

50

100

150

200

250

1990 1995 2000 2005 2006 2007 2008 2009 2010

$ T

ri ll

io n

Equity Securities

Government Debt Securities

Private Debt Securities

Bank Deposits

Total Assets 261 263 321 334 360 376 309 356 356 % of GDP

16-5

Financial Markets Players

Relationship between Lenders and Borrowers

Lenders Financial

Intermediaries Financial Markets

Borrowers

Individuals Companies

Banks Insurance

Companies Pension Funds Mutual Funds

Interbank Stock Exchange Money Market Bond Market

Foreign Exchange

Individuals Companies

Central Government Municipalities

Public Corporations

https://mru.org/dictionary-economics/financial-intermediaries

16-6

Financial Development

Evidence suggest that a developed financial sector is an important driver of economic growth

Illiquid

Liquid

0%

1%

2%

3%

4%

High

Low

Stock Market Liquidity, 1976

per capita GDP growth 1976-98

Banking Development, 1976

16-7

Debt vs. Equity

Stock markets:

◦ provide financing through the issuance of shares

◦ enable the subsequent trading thereof.

Bond markets:

◦ provide financing through the issuance of bonds

◦ enable the subsequent trading thereof.

EQUITY

DEBT

16-8

Debt vs. Equity

Debt Equity

Only interest (no ownership) Ownership

No Voting Rights Voting Rights

Interest payments: tax exempt Dividends: paid after corporation tax

Creditor have legal recourse if payments not made

Shareholders have no legal recourse if dividends not paid

Excess debt can lead to bankruptcy An all-equity financed firm cannot go bankrupt

16-9

0

50

100

150

1 9

7 5

1 9

7 8

1 9

8 1

1 9

8 4

1 9

8 7

1 9

9 0

1 9

9 3

1 9

9 6

1 9

9 9

2 0

0 2

2 0

0 5

2 0

0 8

2 0

1 1

2 0

1 4

2 0

1 7

% G

D P

Stock Market Capitalization SPAIN

Source: World Bank

Market capitalization or market value is the share price times the number of shares outstanding for listed domestic companies.

Investment funds, unit trusts, and companies whose only business goal is to hold shares of other listed companies are excluded.

Equities: Stock markets

Data are end of year values.

https://data.worldbank.org/indicator/CM.MKT.LCAP.GD.ZS?locations=AR&view=chart

16-10

Equities: Stock markets

 1. Stock market capitalization depends on:

 Trade off Equity versus Debt as financing options

 Presence of multinationals increase capitalization

 2. Equities tend to yield greater returns than those earned on most other assets

 3. Why do stock prices or share prices move?

16-11

1. Stock Market Capitalization

0%

50%

100%

150%

200%

250%

% o

f G

D P

16-12

2. Return on Investment

0,1

1

10

100

1000

10000

100000

1000000

1871 1881 1891 1901 1911 1921 1931 1941 1951 1961 1971 1981 1991 2001

D o

ll a rs

Stocks $104,091

Bonds $550

Bills $346

Gold $59

CPI $17

Value of investing $1 in 1871: Massive outperformance of Equity

Over the long term, Equities have generated higher returns than

nearly all other assets.

16-13

3. Stock prices

– Why do share prices move?

– Are fluctuations related to economic fundamentals or the whims of speculators?

– Why have equities in the past tended to yield greater returns than those earned on most other assets?

– Can we expect this excess return on equities to continue into the future?

– Can you beat the market?

It matters greatly whether stock price movements are the result of rational and reasoned responses by investors to information on long- term economic prospects of firms or whether they are the result of a whim.

16-14

The investment decisions of firms are likely to depend, to some extent, on movements in financial

asset prices.

So it would be worrisome if those financial market valuations were dissociated from fundamental

determinants of corporate profitability.

When markets work well, they reward those who are most efficient

at producing what society wants and punish those who are not.

3. Stock prices

16-15

3. Are price fluctuations related to economic

fundamentals or to speculators?

https://www.bbc.com/news/business-51903195

16-16

Determination of Stock Prices

 Expected rate of return = expected capital gain (sale price-purchase price)+ expected dividend payment

 Required rate of return = return necessary to induce person to purchase the asset

 Expected rate of return should equal required rate of return

16-17

Determination of Stock Prices:

Option 1: with capital gains

P(1) – P(0)

P(0) = r

D(1)

P(0) +

Expected Capital Gains

Dividend Yield

Required rate of return

16-18

Determination of Stock Prices:

Option 2: without capital gains

= r – g D(1)

P(0)

Dividend Yield

Required rate of return

Anticipated LR growth rate of dividends

Low dividend yield: • Optimism about LR growth in dividends • Less risky so lower rate of return

Example: If D (1) is 2, r is 0,1% and g is 0,05%, how much is the Price of the stock?

16-19

Fundamental value of equity

 Today’s price reflects discounted expected value of all future dividends

 Price should reflect the underlying profitability of a company

16-20

Unpredictability

 Notice: importance of expected future dividends

 How are expectations formed?

 Rationally + forward looking

 P(0) considering 10% future increase in dividends

 What if it is finally a 15% increase in dividends?

 What if it is finally a 5% increase in dividends?

Random walk stock prices are perfectly rational and efficient.

16-21

Determination of Stock Prices:

Risk premium

 Risk premium

 How much extra return is required to compensate for risk?

 ‘r’ should reflect both safe return and compensation for risk of unpayment

r = The Required Rate of Return = Safe rate + Risk Premium (Equity Premium)

As long a investors perceive that equities are riskier than other assets, they will have to yield a higher rate of return:

16-22

Practice

 P = D/(r-g)

r=3% and risk premium is 4% => r = 7%

g=2%

So, P/D (price to dividend ratio) =20 = (1/0.05)

Now, risk premium is 2% => r = 5%

So, P/D ratio = 33 = (1/0.03)

A decrease in risk premium will rise the price

16-23

Practice

 In an economy, aggregate dividends paid are expected to rise at the GDP growth rate which is 2.5% per annum. The required rate of return equals a safe real rate (3%) plus a risk premium (5%). What would you expect the dividend price ratio (or the dividend yield) to be? By how much would stock market prices change if the risk premium was 6%?

16-24

Solution to practice

 g=0.025

 r= 0.03+0.05=0.08

 D/P=(r-g) = 0.055 => dividend yield is 5.5%

 Risk premium rises to 6%

 r=0.03+0.06=0.09

 D/P=0.065 => dividend yield is 6.5%

Stock prices fall by 15% when risk premium rises by 20%

16-25

Do options have the same value?

How much would you pay for each?

$50 for sure

•$100 with 50%

chance •$0 with

50% chance

16-26

What about your next job?

$50,000 for sure

Flip a coin. Heads:

$100,000

Tails: $0

16-27

The role of Risk

 Coefficient of risk aversion > 0

 Rather take sure bet than risky bet

 Coefficient of risk aversion < 0

 Rather take risky bet than sure bet

 Coefficient of risk aversion = 0

 Risk neutral

16-28

Speculation

 Momentum & Mean reversion

 Short position: Selling to buy shortly

 Long position: Buying  https://www.quantshare.com/blog-497-mean-reversion-vs-momentum-strategies

 Herding behavior  https://www.investopedia.com/terms/b/behavioralfinance.asp

 https://www.socialsciencespace.com/2017/10/founding-father-behavioral-economics-wins-nobel-prize/

 Bubbles  https://www.investopedia.com/articles/stocks/10/5-steps-of-a-bubble.asp

Have irrational sentiments any influence of prices?

What is speculating? https://www.investopedia.com/terms/s/speculation.asp

Ted-Ed Bubbles

16-29

Speculation: Bubbles

 “When I see a bubble first I do is "I buy" because if I am right and the bubble is going

to develop, I am going to make money, and If I see a bubble and I see a flaw in the bubble

then I am really happy, because then I will so know that I have to sell, most bubbles you do

not know that they are bubbles.” (George Soros, Wall Street Journal interview, October

2009)

Crash Course Bubbles

To watch at home:

https://www.youtube.com/results?search_query=inside+job

16-30

Bonds (IOU, “I owe you”)

 Debt claim (loan)

 Traded on securities markets

 Detailed repayment schedule

 “Fixed income securities”

16-31

Who issues debt?

 Private corporations

 Financial Institutions

 Government

16-32

The Price of a Bond

 The Price of a bond reflects the value today of all the streams of cash that it will generate in the future.

 Price of a bond = discounted value of all the repayments on payments plus a final payment in the last period of the bond´s life (Face Value at redemption date)

= discounted sum of future expected coupons and final repayment.

 Yield of bond = rate of return

16-33

Bond Prices & Yields

Bond A

Purchase at price $102

(P)

Pays $5 (C)

Coupon of $5 and redeem at

$100 (F)

Year 1 Year 2

( ) ( )

( ) %9.3039., 1

100$5$

1

5$ 102$

2 ==

+ ++

+ = yieldy

yy

16-34

Price and yield

( ) ( )

( ) %9.3039., 1

100$5$

1

5$ 102$

2 ==

+ ++

+ = yieldy

yy

( ) ( )

( ) %505., 1

100$5$

1

5$ 100$

2 ==

+ ++

+ = yieldy

yy

( ) ( )

( ) %1.6061., 1

100$5$

1

5$ 98$

2 ==

+ ++

+ = yieldy

yy

16-35

Price and Yield B

o n

d P

ri c e

Yield to Maturity

The yield to maturity = a measure of the average rate of return that a buyer will earn on a bond if the buyer holds it to maturity

The higher the price you pay today, less you will earn on averge over the bond´s life. Reason: unlike equity, it is a fixed-income security

16-36

Bond A Collect $100

Bank Deposit

Earn Interest

Withdraw savings

=(1+r1)(1+r2)…P

10-year bond For simplicity: assume no payments until final date: Zero-coupon

Put money in the bank and leave it 10 years

What determines the yield? Short-term interest rates

Price and Yield

16-37

• To be indifferent between both investments, the yield on the 10-year government bond should be nearly the same as the average interest rate that we think we are going to earn on bank deposits if we hold them for 10 years.

• Suppose the 10 year bond yield is higher:

• people buy bonds.

• The demand for bonds increases so their prices rise, and it will decrease their yield.

• Banks, to attract clients would increase rate: in equil., should be equal.

• The yield is the average of the short-term interest rates

• Expectation of future interest rates affect yields

 If expected interest rates to rise: yield curve will rise.

 If expected interest rates to decrease: yield decrease.

• Price movements are greater for longer-term bonds

What determines the yield The role of interest rates

16-38

What determines the yield The role of interest rates

 The yield is the average of the relevant interest rates

 Importance of expectation of future interest rates

 Price movements are greater for longer-term bonds

 The yield predicts future inflation

 5year bond yield > ST interest rate => future 5year inflation rises

 Economic recovering after a recession and rising interest rates  yield curve is upward sloping

 Slower growth after a boom and lower interest rates  yield curve is downward sloping

 Yields vary across countries (so do interest rates)

 Exchange rate

16-39

Bonds are fixed-income securities. The amount of cash that you are going to get in the future from holding a bond does not change when interest rates and yields move, but the present value of that cash does. Bond prices rise, leading to capital gains for bond holders.

On the contrary: Depositors of banks, other things equal, are better when interest rates rise as depositor´s interest rates increase.

16-40

Government Policy

 Expectations theory of the yield curve

 Expectation of fall in short term rates

 Downward sloping yield curve

 Expectation of rise in short term rates

 Upward sloping yield curve

 Use of the yield curve to predict inflation

16-41

Information in the Yield Curve

 Absolute levels of bond yields are related to short term rates

 y=15% => very high future inflation => Restrictive monetary policy

 Slope of the yield curve is related to the slowing down or accelerating economic growth

 Via movement in monetary policy

 Spread between government and corporate bonds

 The higher the spread the higher the perception about bankruptcy (and default) risk in highly indebted firms.

16-42

 A downward sloping yield curve means:

1. A lower yield in the long term bonds.

2. Expectations of decreasing interest rates in the future

3. Expectations of expansionary monetary policy in the future.

4. Expectations of lower growth in the economy in the future.

16-43

EXAMPLE:

1. An economy emerges from a recession: short-term interest rates are low.

2. The economy improves.

3. Expect Central Bank to rise future short-term interest rates gradually.

4. The yield curve will tend to slope upwards.

16-44

Summary

 Global Financial Assets

 Equities

 Determination of Stock Prices

 Risk and Speculation

 Bond markets

 Prices and Yields

 Relationship to monetary policy

 Use of the yield curve to anticipate future economic events

Copyright © 2012 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained therein.