Bonds & Stock Market (9/21/2010)
Econ 310
004
Equations
•
i
nt
= (i
t
+ i
e
t+1
+ i
e
t+2
+ … + i
e
t+(n–1)
)/n
Expectations formula
•
i
nt
= (i
t
+ i
e
t+1
+ i
e
t+2
+ … + i
e
t+(n–1)
)/n + l
nt
Liquidity premium formula
•
p
0
= D
1
/(1 + k
e
) + p
1
/(1 + k
e
)
OnePeriod Stock Valuation Model
•
p
0
= D
1
/(1 + k
e
)
1
+ D
2
/(1 + k
e
)
2
+ …
Dividend Valuation Model
+ D
n
/(1 + k
e
)
n
+ p
n
e
/(1 + k
e
)
n
o
fundamentals: D
1
/(1 + k
e
)
1
+ … + D
n
/(1 + k
e
)
n
o
bubble: p
n
e
/(1 + k
e
)
n
•
p
0
= D
∑
t
/(1 + k
e
)
t
Dividend Valuation Model without final
sale
•
p
0
= D
0
(1 + g)
1
/(1 + k
e
)
1
+ D
0
(1 + g)
2
/(1 + k
e
)
2
+
Gordon Growth Model
… + D
0
(1 + g)
∞
/(1 + k
e
)
∞
•
p
0
= D
0
(1 + g)/(k
e
– g) = D
1
/(k
e
– g)
Gordon Growth Model (simplified)
Definitions
•
risk structure of interest rates
– the relationship among the interest rates on various
bonds with the same term to maturity
•
term structure of interest rates
– the relationship among the interest rates on various
bonds with different terms to maturity
•
default
– party issuing debt instrument is unable to make interest payments or pay off the
amount owed at maturity
•
defaultfree bonds
– bonds with no default risk
•
risk premium
– interest rate spread between bonds with default risk and defaultfree
bonds
•
yield curve
– plot of the yields of bonds with differing terms to maturity but the same risk
structure (risk, liquidity, and tax considerations)
•
inverted yield curve
– downward sloping yield curve
•
expectations theory
– the interest rate of a longterm bond will equal the average of short
term interest rates people expect over the life of the longterm bond
o
Assumption: Bonds of different maturities are perfect substitutes.
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 Fall '08
 Staff
 Interest Rates, Yield Curve, default risk

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