CH18 - 18 F INANCIAL M ARKETS AND A SSET P RICES FOCUS OF...

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Unformatted text preview: 18 F INANCIAL M ARKETS AND A SSET P RICES FOCUS OF THE CHAPTER • Financial markets are the vehicle through which macroeconomic affect the lives of everyday people; fluctuations in the stock market directly affect people’s income and wealth; changes in interest rates affect our ability to buy a home, or a car. • This chapter examines the behavior of three markets: the bond market, the stock market, and the market for foreign exchange. • All of these markets are forward-looking ; asset prices reflect people’s expectations of future returns. As a result, changes in these asset prices are unpredictable . SECTION SUMMARIES 1. Interest Rates Long-Term and Short There is more than one interest rate in the economy; bonds of different maturities, in particular, have different interest rates. The relationship between the interest rates paid on bonds of differing maturity is called the term structure of interest . Interest rates on long-term bonds are typically higher than interest rates on short-term bonds. Because holding one long-term bond is equivalent to holding a series of short-term bonds, the interest rate on long-term bonds is equal to the average of the current interest rate on short- term bonds and expected future short-term interest rates, plus a term premium which compensates the holder for the risk associated with holding long- rather than short-term bonds . Long-term bonds are typically perceived as riskier than short-term bonds because of their greater price volatility (variation in price). The expectations theory of the term structure highlights the way that people’s expectations of future short-term interest rates affect current long-term interest rates. The text observes that term premia vary over time. The yield curve shows the relationship between interest rates on assets of different maturities. Because long-term interest rates are typically higher than short-term interest rates, the yield 196 197 C HAPTER 18 curve is usually upward- sloping. A downward- sloping yield curve implies that people must expect short-term interest rates to fall in the future; this is sometimes a recessionary signal. Boxes in the chapter work through the details of calculating the net present value of assets whose payoff occurs in the future, and discuss the relationship between the net present value of a bond’s coupon payments plus face value and its price. Increases in interest rates are shown to reduce bond prices particularly long-term...
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This note was uploaded on 12/02/2011 for the course ECON 209 taught by Professor Dr.martin during the Spring '09 term at Charleston.

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CH18 - 18 F INANCIAL M ARKETS AND A SSET P RICES FOCUS OF...

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