Money & Banking Exam 2

Three theories of the term structure of interest rates

1) expectation theory 2) segmented markets theory 3) liquidity premium theory

Efficient markets hypothesis is on application of rational expectations to financial markets (EMH)

1) if financial markets are efficient, stock prices only change when new, unanticipated information is released 2) Since unanticipated information is equally likely to be good or bad, stock price movements are random

Three term structure observations

1) interest rates on bonds with different maturities tend to move together 2) yield curves usually slope up when short term rates are low and slow down when short term rates are high 3) usually yield curves are upward sloping

A plot of the yields on bonds with different terms to maturity but the same risk, liquidity, and tax considerations is known as

A yield curve

A plate of the yields on bonds with different terms to maturity but the same risk, liquidity, and tax considerations is known as

A yield curve A yield curve is a plot of the yields of bonds that only differ on the terms of their maturity

Interest rates have been at 6% for the past four years. The economy goes into a recession causing the Fed chairperson to announce an expansionary monetary policy with an interest rate target of 2%. You forecast interest rates for next year to be 6%. This is an example of applying the theory of

Adaptive expectations

Liquidity premium theory

Assumes bond investors view bonds with different maturities as substitutes but not perfect substitutes People care about both expected returns and maturities Other things held equal they prefer short to long term bonds

Gordon growth model

Assumes that dividends grow at rate g (ex. D2=D1 * (1+g)) Po=D1/(Ke-g)

Expectations Theory

Assumption: bond investors view bonds with different matures as perfect substitutes. In other words, bond investors care about expected returns and not maturities.

Social contagion or herd behavior

Cognitive dissonance- a judgmental bias people make because they don't want to admit they are wrong

Yield Curve

Describes the term structure of interest rates for particular types of bonds Curves can be classified as upward sloping, downward sloping, or flat. (Inverted yield curves are downward sloping) When yield curves are upward sloping (most common)- long term interest rates are above short term interest rates When yield curves are flat- short and long term interest rates are the same When yield curves are inverted- long term interest rates are below short term interest rates

According to the Generalized Dividend Model, the final sales price of a stock depends on

Dividend payments Number of periods Required return on investments equity

Announcements of unknown information

Generate unexploited profit opportunities

Theories of stock valuation

In general, the value of an asset is the present value of all the future cash flows the asset will generate

What effect would reducing income tax rates have on the interest rates of municipal bonds?

Interest rates would rise because the reduction in income tax rates would make the tax-except privilege for municipal bonds less valuable and reduce the demand for municipal bonds

Capital asset pricing model

Ke=required return on equity investments Ke is based on a risk-free return plus a risk premium associated with owning the stock The risk premiums has two parts: 1. A market rick premium 2. Firm specific risk premium Firm specific risk premium (Beta) measure the overall sensitivity of a stock's price relative to changes in the overall stock's market The larger a stocks (Beta), the greater the stock's firm-specific risk CAP^m K^j e= Kf + B^j (Ke^m - Kf) Ke^j= expected return on asses j Kf= risk free rate of return B^j= firm specific sick for asset j Ke^m= the expected return on the overall stock market B^j(K^m e - Kf)= risk premium on asset j

Liquidity premium and preferred habitat theories

Liquidity premium theory- the interest rate on a long term bond will equal an average of short term interest rates expected to occur over the life of the long term bond plus a liquidity premium that responds to supply and demand conditions for that bond Key assumption is that bonds of different maturities are substitutes which means that the expected return on one bond does influence the expected return on a bond of a different maturity (however theory allows investors to prefer one bond maturity over another) (Bonds of different maturities are assumed to be substitutes but not perfect substitutes) Preferred habitat theory- takes a somewhat direct approach to modifying the expectations hypothesis but comes to a similar conclusion. It assumes that investors have a preference for bonds of one maturity over bonds of another

If you read in the Wall Street Journal that the "smart money" on Wall Street expects stock prices to fall, you should:

Not sell all of your stocks because this is publicly available information and is already reflected in stock prices

The current price Pt of a share of DuWop ( a publicly traded company) is $25. Which of the following price movements (in the next time period, Pt+1) is consistently with a random walk?

P t+1, is $28 with a probability of .50 and P t+1 is $24 with a probability of .50

There are many faults associated with adaptive expectations except that

Past data do no help predict future values of variables

Dividends

Payments made periodically, usually every quarter, to stock holders

If a company called Advanced technologies has set to pay a dividend on its stock, the generalized dividend model predicts that the company's tock may still have value because

People expect Advanced Technologies to pay dividends in the future

One period valuation model

Po= (D1/(1+Ke))+(P1/(1+Ke)) Po= current stock price D1= dividend paid at end of year 1 P1= price of stock at end of year 1 Ke= required return on equity investment

Generalized dividend valuation model

Po= Dt/(1+Ke)^t

What basic principle of finance can be applied to the valuation of any investment asset?

Present Value

The efficient market hypothesis implies that

Prices in markets like the stock market are unpredictable

Statements about rational expectations

Rational expectations are identical to optimal forecasts Rational expectations are different from adaptive expectations Rational expectations may not be accurate The efficient market hypothesis is an application of the theory of rational expectation.

According to the Generalized Dividend Model, the final sales price of a stock depends on the following

Required return on investments in equity Number of periods Dividend payments

Segmented Markets Theory

Sees markets for different-maturity bonds as completely separate and segmented. The interest rate on a bond of a particular maturity is then determined by the supply of and demand for that bond, and is not affected by expected returns on other bonds with other maturities. Key assumption of the segmented markets theory is that bonds of different maturities are not substitutes at all, and so the expected return from holding a bond of one maturity has no effect on the demand for a bond of another maturity.

Yield curves and the markets expectations of future short term interest rates according to the liquidity premium theory

Steeply upward sloping yield curve- indicates that short term interest rates are expected to rise in the future Mildly upward sloping yield curve- indicates that short term interest rates are not expected to rise or fall much in the future Flat yield curve- Indicates that short term rates are expected to fall moderately in the future. Downward sloping yield curve- Indicates that short term interest rates are expected to fall sharply in the future

Segmented Markets

The interest rate for each bond with a different maturity is determined by the puppy and demand for that bond, with no effects from expected returns on other bonds with other maturities

Preferred Habitat

The interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium (also referred as a term premium) that responds to supply and demand conditions for that bond

Expectations Theory

The interest rate on a long-term bond will equal an average of the short-term interest rates that people expect to occur over the life of the long term bond

If a yield curve is upward sloping, what is the market predicting about the movement of future short-term interest rates?

The market is predicting that the future short-term interest rates will increase What might the yield curve indicate about the markets predictions for the inflation rate in the future? The market's predictions indicate that inflation will be higher in the future

According to the segmented markets theory of the term structure of interest rates, if bondholders prefer short term bonds to long-term bonds

The yield curve will be upward sloping The segmented markets theory indicates that if bondholders prefer short-term bonds to long-term bonds, they will have to be compensated more to purchase long-term bonds. Therefore, the yield curve is upward sloping.

The term structure of interest rates

Tries to explain why two otherwise identical bonds with different maturities, but are otherwise identical, have different yields

The generalized dividend valuation model

Using the present value concept, we can extend the one year period dividend valuation model to any number of periods: The value of a stock today is the present value of all future cash flows Po= D1/(1+Ke)^1 + D2/(1+Ke)^2 + ...+ Dn/(1+Ke)^n + Pn/(1+Ke)^n or Po= (sideways m) Dt/(1+Ke)^t The generalized dividend model states that the price of a stock is determined only by the present value of the dividends and that nothing matters Buyers of the stock expect that the firm will pay dividends someday

True

When short-term interest rates are high, yield curves tend to be downward sloping Yield curves almost always slope upward Interest rates on bonds of different maturities tend to move together over time There are several facts about interest rates. First is that interest rates of bonds tend to move together over time. The second is that yield curves almost always slope upward while the third is that when short-term interest rates are high, yield curves tend to be downward sloping.

Would interest rates of Treasury securities be affected by the tax rate change

Yes, because the reduction in the tax-except privilege in municipal bonds would raise the relative value of Treasury securities, making Treasury securities more desirable

Suppose that increases in the money supply lead to a rise in stock prices. Should you go out an buy stocks?

You should not buy stocks because the rise in the money supply is publicly available information that will be already incorporated into stock prices

If the yield curve suddenly becomes steeper, how would you revise your predictions of interest rates in the future?

You would raise your predictions of future interest rates

Unexploited profit opportunities

are quickly eliminated by arbitrage

Efficient markets hypothesis

based on theory of rational expectations- expectations are formed by looking at all available information X^e=X^of expectations based on optimal forecast-> forecast errors will on average be 0

Statement about market bubbles

bubbles can occur when investors buy an asset above its fundamental price in the belief that someone else will buy the asset for a higher price in the future

Are all markets efficient

evidence is mixed some markets more efficient than other

According to the liquidity premium and preferred habitat theories of the term structure of interest rates, a flat yield curve indicates that

future short-term interest rates are expected to fall Based on the liquidity premium and preferred habitat theories, a flat yield curve indicates that future short-term interest rates are expected to fall since the term premium is positive and is countering the decline in the interest rates

Suppose a change in the way a variable moves such that it is much larger than before. If adaptive expectations accurately represents how people form expectations, then the difference between the variable and its expected value is

greater than zero

With expectations theory

if people expect short term rates are going to be high its going to drive long term rates high (b/c perf subs)

When the risk premium increases

it is more like that the economy is entering a recession

When risk premium decreases

it is more likely that the economy is entering an expansion

Segmented markets theory

main assumption: none investors don't view bonds with different maturities as substitutes at all (care about maturities --> not expected returns) Assume other things equal people prefer short term bonds to long term bonds because short term bonds have less "interest rate risk" can explain observation #3 (but not #1 & #2)

The liquidity premium theory, the equation for the interest rate on a 3 year bond is given by

r=((i(1)+i(2)+i(3))/3)+p where r= interest rate on the three year bond i(t)= expected interest rate on the one-year bond p= liquidity premium on a three year bond

Gordon growth model

simplified model of the general dividend model which assumes constant dividend growth Many firms strive to increase their dividends at a constant rate each year.... Po= Do * (1+g)^1/ (1+Ke)^1 + DoX * (1+g)^2/ (1+Ke)^2 + ... + DoX(1+g) ^(infinity)/ (1+Ke) ^ (infinity)

common stock

the principal medium through which corporations raise equity capical

stock holders

those who hold stock in a corporation- own interest in the corporation equal to the percentage of outstanding shares they own

One-period valuation model

you buy a stock, hold it for one period to get a dividend, then sell the stock Need to determine whether the current price accurately reflects the analysts forecast. To value stock today need to find the presented discounted value of the expected cash flow (future payments) Po=D1/(1+Ke) + P1/(1+Ke) Po= the current price of the stock D1= the dividend paid at the end of year 1 Ke= the required return on investment in quite P1= the price at the end of the first period; the predicted sales price of the stock

A good theory in the term structure of interest rates bus explain the follow 3 empirical facts

1) interest rate bonds of different maturities move together over time 2) When short term interest rates are low, yield curves are more likely to have an upward slop; when short-term interest rates are high, yield curves are more likely to slope downward and be inverted 3) yield curves almost always slope upward

Stock Valuation models

1) one-period valuation model 2) generalized dividend valuation model 3) gordon growth model 4) capital asset pricing model

3 forms of EMH

1) weak form (random walk hypothesis)= All past market data is reflected in stock prices)--> Technical analysis not useful 2) semi-strong= All publicly available information is reflected in stock prices--> fundamental analysis is not useful 3) strong form= All public and private information is reflected in stock prices--> can't benefit from insider trading

Three term structure observations

1) yields on bonds with different maturities tend to move together 2) yield curves tend to slope up when short term rates are low and down when short term rates are high 3) yield curves usually slope up

Yield curve

A graph showing the yields on otherwise identical bonds with different maturities (inverting yield curve when downward sloping- inverted yield curve is a good predictor of a RECESSION) (the yield curve moves when interest rates change)

According to the efficient market hypothesis, in order to earn abnormally high returns, an investor would need to have

Exclusive information

Expectations theory

The interest rate on a long-term bond will equal the average of the short term interest rates that people expect to occur over the life of the long term bonds The key assumption behind this theory is that buyers of bonds do not prefer bonds of one maturity over another, so they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity. When the yield curve is upward sloping the expectations theory suggests that short term interest rates are expected to rise in the future When the yield curve is inverted (slopes downward), the average of future short term interest rates is expected to be lower than the current short term rate, implying that short term interest rates are expected to fall, on average, in the future. Only when the yield verse is flat dow the expectations theory suggest that short-term interest rates are not expected to change, on average, in the future. Explains fact 1 & 2 but not 3

If expectations of future short-term interest rates suddenly fall, what would happen to the slope of the yield curve?

The yield curve would become flatter

Why do stock market events like October 1987 or the technology crash of 2000-2001 cast doubt on the efficient market hypothesis?

There may be unexploited profit opportunities in these events

Liquidity premium formula

l Subscript nt equals i Subscript nt minus StartFraction i Subscript t Baseline plus i Subscript t plus 1 Superscript e Baseline plus i Subscript t plus 2 Superscript e Baseline plus ... plus i Subscript t plus left parenthesis n minus 1 right parenthesis Superscript e Over n EndFractionlnt=int− it+iet+1+iet+2+...+iet+(n−1) n where int ​= current rate on a multiyear horizon bond it ​= ​today's (time t​) interest rate on a​ one-period bond i Subscript t plus n Superscript eiet+n ​= ​one-period interest rate expected to occur over the n​-period life of the bond n ​= number of periods

Regret Theory

people fear the pain of regret. They make bad decisions when they are overly worried about regret.

residual claimant

the stick holder receives whatever remains after all other claims against the firm have been satisfied